Bond Market Outlook: Why U.S. Treasuries Look Expensive Ahead of the Upcoming Rate-Cutting Cycle

Summary:

• Inflation Expectations Drive the Rally: Falling breakeven rates, triggered by lower oil prices and economic weakness, suggest markets are pricing in inflation below the Fed’s 2% target, driving the bond rally.
• Limited Room for Further Gains: 10-year Treasury yields have already dropped significantly, reducing the potential for further declines, especially if a recession doesn’t materialize.
• Underpriced Inflation Risk: The market is underestimating the potential for inflation to rebound, which could lead to rising yields and declining bond prices if inflationary pressures return.

Introduction

The recent rally in U.S. Treasury (UST) bonds has raised questions about the sustainability of current pricing levels. Historically, bond yields tend to decline heading into an easing cycle, driven primarily by lower real yields and wider breakeven rates, as the Federal Reserve cuts rates to stimulate the economy.

However, this time, we are seeing an unusual pattern. Despite expectations of a prolonged and aggressive easing cycle, breakeven rates have fallen faster than real rates, signaling that markets are pricing inflation to fall below the Fed’s 2% target. This is surprising because, typically, Fed rate cuts would lead to higher long-term breakeven inflation rates, as monetary easing stimulates the economy.

The disconnect between falling breakeven rates (signaling lower inflation expectations) and more resilient real yields (indicating tighter policy) reflects the uncertainty in the current market environment. Markets are anticipating lower inflation due to slowing economic activity, but the higher real yields suggest that, for the Fed to meaningfully shift policy, it may need to cut rates more aggressively than currently expected. Elevated real yields are also a sign that investors are hedging against persistent economic headwinds rather than a complete breakdown in economic fundamentals.

What Is Driving the Recent Rally in US Treasuries?

The recent rally in Treasuries, particularly the decline in 10-year yields, has been driven by expectations of economic weakness. Several key factors have contributed to this:

1. Oil Prices and Inflation Expectations:
   A key trigger for the bond rally has been the decline in crude oil prices. Oil falling below $70 per barrel, its lowest level since December 2021, has heightened fears that inflation may undershoot the Fed’s target. This drop in inflation expectations has led investors to move into Treasuries, pushing yields lower. The 10-year breakeven inflation rate, which measures expected inflation over the next decade, has fallen to 2.02% — the lowest since 2021. Even more telling, breakeven rates for shorter-term bonds (up to 5 years) have fallen below the Fed’s 2% target. This indicates that investors are now pricing in the possibility of inflation undershooting over the medium term, reinforcing expectations of an aggressive rate-cutting cycle by the Fed.
2. Breakeven Rates and Real Yields:
   Interestingly, the decline in yields has been primarily driven by falling breakeven rates, rather than real yields. While breakeven rates have dropped significantly, real yields (which are tied to inflation-protected securities or TIPS) have only fallen to levels last seen in July of last year. This disconnect highlights that inflation expectations are driving the rally, rather than a significant deterioration in real economic conditions. Elevated real yields reflect a restrictive policy environment, meaning that for the Federal Reserve to become less restrictive, it may need to cut rates more aggressively than markets currently expect.