The Fed slashed interest rates last week, but Treasury yields are rising. What's going on?

With its larger-than-normal cut last week, the Federal Reserve sent a clear message that interest rates are heading considerably lower in the future.

The Treasury market, though, hasn’t been paying attention.

Despite the Fed approving a half percentage point reduction in its baseline short-term borrowing rate, Treasury yields instead have been moving higher, particularly at the long end of the curve.

The 10-year note yield, considered the benchmark for government bond yields, has leaped about 17 basis points since the Federal Open Market Committee meeting of Sept. 17-18 — reversing what had been a sharp decline throughout September. (One basis point equals 0.01%.)

For now, bond market professionals are writing off a good portion of the move as a simple makeup for markets pricing in too much easing before the Fed meeting. But the trend bears watching, as it could signal something more ominous ahead.

Other reasons cited for the move include the Fed’s willingness to tolerate higher inflation, as well as concerns over the precarious U.S. fiscal situation and the potential that an onerous debt and deficit burden could raise long-term borrowing costs no matter what the Fed does.

“To a certain extent, there was just an element of people buying the rumor and selling the fact as it relates to the actual FOMC decision last week,” said Jonathan Duensing, head of U.S. fixed income at Amundi US. “The market already had discounted a very aggressive easing cycle.”

Indeed, the market had been pricing in larger rate cuts than what Fed officials had indicated at the meeting, even with the 50 basis point move. Officials penciled in another 50 basis points in reductions by the end of the year and another 100 by the end of 2025. By contrast, markets expect another 200 basis points of cuts in the same period, according to fed funds futures pricing as gauged by the CME Group’s FedWatch tracker.

But while longer-duration notes like the 10-year have seen yields surge, those on the shorter end of the curve — including the closely followed 2-year note — haven’t moved much at all.

This is where it gets tricky.

The difference between the 10- and 2-year notes has widened significantly, increasing by about 12 basis points since the Fed meeting. That move, particularly when longer-dated yields are rising faster, is called a “bear steepener” in market parlance. That’s because it generally coincides with the bond market anticipating higher inflation ahead.

That’s no coincidence: Some bond market experts interpreted Fed officials’ commentary that they are focusing more now on supporting the softening labor market as an admission that they’re willing to tolerate a little higher inflation than normal.

That sentiment is evident in the “breakeven” inflation rate, or the difference between standard Treasury and Treasury Inflation Protected Securities yields. The 5-year breakeven rate, for instance, has risen 8 basis points since the Fed meeting and is up 20 basis points since Sept. 11.

“The Fed has justifiably shifted because they’re confident inflation is under control but they’re seeing a rise in unemployment and a rate of job creation that clearly appears to be insufficient,” said Robert Tipp, chief investment strategist at PGIM Fixed Income. The rise in long-duration yields “is definitely an indication that the market sees risks that inflation can be higher and [the Fed] will not care.”

Fed officials aim for a 2% inflation rate, and none of the principal gauges are there yet. The closest is the Fed’s favorite personal consumption expenditures price index, which was at 2.5% in July and is expected to show a 2.2% rate in August.

Policymakers insist that they’re equally focused on making sure inflation doesn’t turn around and start moving higher, as has happened in the past when the Fed eased too quickly.

But markets see the Fed with a closer focus on the labor market and on not pushing the broader economy into an unnecessary slowdown or recession brought on by too much tightening.

“We’re taking collectively the Fed and Chair [Jerome] Powell at its word that they’re going to be very data dependent,” Duensing said. “As it relates to the softening in the labor market, they are very willing and interested to cut another 50 basis points here as we get into the post-election meetings coming up. They stand ready to approve and accommodation they need to at this point.”

Then there’s the debt and deficit issues.

Higher borrowing costs have pushed financing costs for the budget deficit this year over the $1 trillion mark for the first time. While lower rates would help lessen that burden, longer-duration Treasury buyers could be scared into investing into a fiscal situation where the deficit is approaching 7% of gross domestic product, virtually unheard of during U.S. economic expansions.

Taken together, the various dynamics in the Treasury market are making it a difficult time for investors. All of the fixed income investors interviewed for this article said they are lightening up on Treasury allocations as conditions remain volatile.

They also think the Fed might not be done with big rate cuts.

“If we start to see that [yield] curve steepen, then we probably start to set the alarm bells off on recession risks,” said Tom Garretson, senior portfolio strategist for fixed income at RBC Wealth Management. “They’d still probably like to follow through with at least one more 50 basis point move this year. There’s still an ongoing, lingering fear here that they’re a bit late to the game.”