The U.S. bond market is experiencing a "rare divergence in thirty years": on the eve of the Federal Reserve's interest rate cut, long-term U.S. bond yields are "rising instead of falling."

Since the Federal Reserve began this round of interest rate cuts in September 2024, it has cumulatively lowered the benchmark interest rate by 1.5 percentage points to a range of 3.75%-4%. However, the market's reaction has been unexpected. During the same period, the yield on the 10-year U.S. Treasury bond has risen by nearly 0.5 percentage points to 4.1%, while the increase in the yield on the 30-year Treasury bond has exceeded 0.8 percentage points.

This trend directly challenges traditional market logic, which holds that Fed rate cuts typically lead to a decline in long-term interest rates. It also contradicts the expectations of U.S. President Trump, who believes that faster rate cuts will effectively lower mortgage, credit card, and other loan rates. The market's unusual performance indicates a significant divergence between investors' assessments of interest rate prospects and those of the Federal Reserve.

Currently, there are various interpretations of this divergence in the market. Optimists view it as a reflection of confidence that the economy will avoid recession; neutral viewpoints see it as a sign that market rates are returning to the norms seen before the 2008 financial crisis; while pessimists worry that it reflects the return of "bond vigilantes," who are casting a vote of no confidence in the U.S.'s ever-expanding national debt and potential inflation risks.

Rare Divergence: Rising Yields in a Rate Cut Cycle

Typically, when the Federal Reserve adjusts its short-term policy rates, long-term bond yields move accordingly. However, the performance in this cycle has broken the norm.

Data shows that traders widely expect the Federal Reserve to cut rates by another 25 basis points after this week's meeting and anticipate two more cuts of the same magnitude next year, bringing the policy rate down to around 3%.

However, the key Treasury yields, which serve as benchmarks for borrowing costs for U.S. consumers and businesses, have not declined accordingly.

Looking back at the only two non-recessionary rate cut cycles in the past forty years (1995 and 1998), the Federal Reserve only cut rates by 75 basis points at that time, and the 10-year Treasury yield either fell directly or increased by far less than the current levels.

Soft Landing Expectations or Return to Normalcy?

Regarding the reasons for the rising yields, Jay Barry, Global Rates Strategist at JP Morgan, believes there are two factors at play.

First, due to the unprecedented rate hikes taken by the Federal Reserve in the post-pandemic era to curb inflation, the market had already priced in expectations of a policy shift before the Fed actually began cutting rates, leading to the 10-year yield peaking by the end of 2023.

Second, he pointed out that the Fed's decision to cut rates while inflation remains high is intended to "sustain this economic expansion rather than end it," which reduces the risk of economic recession and thus limits the downward space for yields.

Robert Tipp, Chief Investment Strategist for Fixed Income at PGIM, expressed a similar view, suggesting that this is more like a "return to normalcy," meaning that interest rate levels are returning to those seen before the 2008 global financial crisis. That crisis ushered in an era of abnormally low interest rates, which has abruptly ended in the post-pandemic period

Inflation Concerns and the Return of "Bond Vigilantes"

However, some market participants see more disturbing signals from the so-called "term premium." The term premium is the extra yield compensation that investors require for holding long-term bonds to hedge against potential risks such as future inflation or debt defaults. According to estimates from the New York Federal Reserve, this premium has risen by nearly one percentage point since the current rate-cutting cycle began.

Jim Bianco, president of Bianco Research, believes that this is a clear signal indicating that bond traders are worried that the Federal Reserve is cutting rates too quickly while inflation remains stubbornly above the 2% target and the economy continues to show resilience. He warns: "What the market is really worried about is the policy itself," and if the Federal Reserve continues to cut rates, mortgage rates could "skyrocket vertically."

In addition, political factors have also intensified market concerns. There are worries that President Trump may successfully pressure the Federal Reserve into more aggressive rate cuts. According to Bloomberg, the White House National Economic Council Director, a staunch supporter of Trump, is seen in the betting markets as a leading candidate to replace Chairman Powell. Steven Barrow, head of G10 strategy at Standard Bank in London, bluntly stated: "Putting a politician in charge of the Federal Reserve will not lower bond yields."

From the "Greenspan Conundrum" to Supply Overhang: Is a Structural Shift Happening?

Deeper analysis points to a structural shift in the global macroeconomy. Barrow from Standard Bank likens the current situation to a mirror reversal of the "Greenspan conundrum" from the mid-2000s.

At that time, then-Federal Reserve Chairman Alan Greenspan was puzzled by the phenomenon of his continuous rate hikes while long-term yields remained low.

His successor, Ben Bernanke, later attributed this to a massive influx of overseas excess savings into U.S. Treasuries. Now, Barrow believes the situation is exactly the opposite: the scale of government borrowing in major global economies is too large, and the former "savings glut" has transformed into a "bond supply glut," which exerts persistent upward pressure on yields.

Barrow concludes: "The fact that bond yields are not falling may indicate a structural change. Ultimately, it is not the central bank that determines long-term rates."