Two views on US bonds

Federal Reserve (Fed) Chair Jay Powell struck a somewhat dovish tone during his press conference following the December Federal Open Market Committee (FOMC) meeting, reaffirming his belief in the disinflation process. He reiterated that inflation remained above target due to some lagging service sector categories, like insurance and owners’ equivalent rent, but highlighted significant labor market cooling across a range of different indicators. However, the attempt at dovishness was overshadowed by two hawkish surprises from the FOMC, which rattled markets. The first was the revised dot plot, which now projects only two rate cuts in 2025 where the market had expected three. The second surprise came in the form of a higher core inflation forecast of 2.5%, up from 2.2%. Additionally, these inflation expectations show a bigger skew to the right, meaning more FOMC participants are concerned about upside inflation surprises (see Exhibit 1). This shift is likely due in part to expectations for incoming President Trump’s agenda and the belief that inflation risks are higher due to some yet-unknown mix of policies, whether tariffs, immigration, or fiscal.

Where does the Fed go from here?

The Fed was willing to act pre-emptively, quickly cutting policy rates by 100 basis points since September 2024 because conditions were clearly restrictive. We expect the Fed to be more patient now. Going forward, the Fed is likely to respond to data rather than effectively trying to anticipate it. 

Two views of the US bond market

Our base case scenario is that 10-year Treasury yields will trade in a 4 to 5% range in the coming months. For the past two years, markets have been experiencing a series of mini-tantrums around expectations of Fed policy, both up and down. And this vacillation of markets switching from one side to the other has partly created the range-bound environment for Treasuries. What is uncertain is the skew of the distribution—are yields more likely to rise or fall?

There are several factors that could drive yields higher. The US economy continues to show resilience, bolstered by robust consumer spending and AI-related investments. Global growth could accelerate going forward, driven by the significant easing of financial conditions over the past 12 to 18 months. Further US fiscal stimulus, if not counterbalanced by rising tariffs, could create additional upward pressure on bond yields. Under these conditions, 10-year yields might exceed 5% as markets price in a higher-for-longer Fed policy rate and demand greater term premiums to accommodate expanding fiscal deficits.

On the other hand, the argument for lower yields is based on continuing Fed rate cuts through 2025. Although the US economy grew 2.5% last year, labor market conditions have deteriorated with weaker employment growth and a higher unemployment rate. Employment growth is likely to slow further due to much lower net immigration. Meanwhile, inflation should continue to fall toward the 2% target as service inflation normalizes from the post-pandemic shocks. US trade policy uncertainty is a significant headwind to global growth, and the sharp decline in Chinese bond yields in recent months suggests that China will continue to export disinflation to the rest of the world.

Which way from here?

To determine which of the two bond yield scenarios is most likely, we will closely monitor signals about the timing and severity of potential tariff increases. Also, we will be monitoring how the divergence between US real gross domestic product (GDP) growth and labor market conditions resolves, which will influence Fed policy. While US GDP growth remains decent, labor markets have cooled significantly in a way that is rarely seen. Typically, robust economic growth coincides with strong labor markets (see Exhibit 2).