Wash realized hawkish stance by raising interest rates, and the market chose to believe in the Federal Reserve's determination to control inflation, leading to a decline in U.S. Treasury yields.

Written by: Li Jia, Wall Street Watch

Wash resisted Trump's pressure for interest rate cuts, using the rate hike to prove the Federal Reserve's commitment to controlling inflation—this time, the market chose to believe.

The Federal Reserve restarted rate hikes after three years, temporarily easing the tension in the U.S. Treasury market. On Thursday, the yield on the 10-year U.S. Treasury fell to 4.97%, ending an eight-day streak of increases; the two-year yield also dropped 3 basis points to 4.70%, retreating from the 2024 high reached on Wednesday.

This rate hike had already been fully priced in by the market; what really strained investors was whether the Federal Reserve would refrain from action unexpectedly. If the rate hike did not materialize, doubts about the Federal Reserve’s determination to control inflation could resurface, further impacting the bond market. With the rate hike now in place, this tail risk has temporarily receded, leading to a decline in Treasury yields.

At the same time, the global bond market continues to face pressure. This week, the average yield on global government bonds rose to the highest level since 2007, as the situation in the Middle East drove up oil prices, further strengthening inflation expectations; the pressure on the bond market has extended from U.S. monetary policy to broader factors such as inflation and fiscal supply.

The rate hike is in place, and the market begins to believe in Wash's hawkish path

"The Federal Reserve has no choice; it must give the market a rate hike, or it will face a larger bond sell-off," said Byron Anderson, head of fixed income at Laffer Tengler Investments.

Olumide Owolabi, senior portfolio manager at Neuberger Berman, believes that the market's currently priced rate hikes have exceeded the Federal Reserve's own projections, and interest rates are expected to stabilize at high levels. "We expect rates to stabilize at current highs and will choose to increase duration allocation when the opportunity arises."

Wash's statements have reinforced the market's expectations for further tightening of policy. The Fed's preferred inflation measure, PCE, recorded 3.7% in July, close to the highest level since 2023, significantly above the long-term target of 2%. Wash stated that summer inflation data has not yet shown substantial improvement in underlying inflation trends.

The Fed's dot plot indicates that the median forecast among officials still calls for one more rate hike this year; the interest rate swap market implies expectations of three more rate hikes by mid-2027. Although the implementation of the rate hike has alleviated short-term selling pressure, the market's judgment that rates will remain high has not changed.

Long-term pressure remains, 30-year Treasuries face further upside risk

As short-term rates are repriced, long-term Treasuries must also contend with the combined effects of inflation, fiscal deficits, and government bond supply. Guneet Dhingra, head of U.S. rate strategy at BNP Paribas, suggests shorting 30-year Treasuries, targeting a yield of 5.6%, arguing that the Fed will bring interest rates back into a restrictive range.

Hebe Chen, an analyst at Vantage Global Prime, stated that the impact of this rate hike on the bond market may not be just a temporary shock. The short end needs to reconsider the possibility of further tightening, while the long end is constrained by inflation, large-scale debt issuance, and fiscal risks.

Therefore, the decline in Treasury yields on Thursday appears more like a short-term correction following the rate hike rather than a complete resolution of long-term pressures. As long as inflation remains high and fiscal financing needs persist, long-term yields may still face upward pressure.