The Fed has Cut Rates: What Will Happen to the Yield Curve Next?

Following the Federal Reserve’s decision to implement a 50 basis point rate cut, analysts observed a significant market reaction characterized by a steeper yield curve, largely influenced by movements at the shorter end of the curve.

There has been a slight uptick in inflation expectations, as indicated by the 10-year inflation breakeven rate. Although market rates initially decreased after the rate cut, longer-term rates experienced a modest increase by the close of trading.

According to ING, the trend of curve steepening is expected to persist, with the 10-year Treasury yield limited by its spread to the 10-year SOFR, which is presently around 45 basis points. The bank predicts that this pattern will continue, potentially exerting upward pressure on longer-term rates despite the Fed’s easing measures. They highlight that the Fed’s current outlook remains relatively optimistic regarding the economy, with no immediate concern about mitigating a pronounced slowdown.

ING’s analysis states that “[Powell] perceives the risks as balanced between inflation and the labor market.” The Fed does not appear to be anticipating a recession and will only consider cuts to alleviate restrictive policies.

This situation has resulted in ongoing supply pressures within Treasuries, which further restricts the potential for declines in long-term rates.

Fed Chair Powell has downplayed the possibility of additional 50 basis point cuts, indicating that the Fed is not in a hurry to further reduce rates.

Analysts from Bank of America characterized Wednesday’s rate cut as a “hawkish cut,” suggesting that the Fed’s signals indicate future reductions are likely to be smaller, around 25 basis points, during upcoming meetings.

In the wake of this announcement, the yield curve steepened as long-term yields increased due to heightened demand for duration and reduced foreign exchange hedging costs for international investors. This steepening reflects the market’s confidence in the Fed’s ability to handle inflation while fostering economic growth.

Additionally, Bank of America noted that the market currently anticipates slightly more rate cuts than the Fed has projected, which could lead to further adjustments in the yield curve moving forward.