Hawkish Fed pressures the yield curve, but not the income opportunity

Key Takeaways

• The U.S. Treasury yield curve has ‘bear flattened’ this year, with the trend accelerating over the past month. In other words, short-dated yields have risen significantly more than longer-dated yields.
• The primary driver: a dramatic repricing of Federal Reserve (Fed) policy expectations. Markets increasingly believe the central bank will need to tighten monetary policy further in response to persistent inflation risks against a stable economic backdrop.
• The flattening is notable because it is unfolding despite the persistence of several factors that previously steepened the curve, including elevated fiscal deficits, robust government debt issuance, geopolitical and policy uncertainty, and resilient economic growth.
• In our view, the curve is increasingly reflecting concern that an extended period of restrictive monetary policy could eventually slow economic activity more than desired but also conviction the Fed will tame inflation.

What happened

Historically, the 2-year/10-year yield curve has been widely seen as the market’s take on growth and inflation relative to monetary policy expectations, which has provided a powerful economic signal. Generally, an upward sloping yield curve suggests a monetary policy stance that is well-positioned to support an economic expansion. Conversely, a flattening yield curve can signal hawkish monetary policy expectations and/or a deteriorating growth outlook.

Over the past month, the 2-year/10-year U.S. Treasury yield curve has undergone a relatively sharp flattening, recently touching its shallowest trajectory since early 2025. The spread between 2-year and 10-year U.S. Treasury yields has narrowed significantly from roughly 70 basis points (0.70%) at the start of 2026 to just 26 basis points (0.26%) today. Almost 30 basis points (0.30%) of the flattening has occurred since mid-August alone. Fixed income yields are higher across all maturities this year; however, short-dated yields have risen more relative to longer-dated maturities (i.e., a bear flattener).

U.S. Treasury yields from 5 to 30 years are flirting with multi-decade highs. Investors with longer horizons continue to demand additional compensation for several perceived risks: above-target inflation, growing federal deficits, persistent U.S. Treasury debt issuance, and geopolitical risks. Concerns surrounding the long-term fiscal trajectory of the United States are nothing new but are still exerting upward pressure on long-dated yields.

For much of the past three years, these forces have placed greater upward pressure on longer-term yields relative to short-term interest rates, which are more sensitive to Fed policy and forward-looking Fed expectations. For instance, the yield curve steepened steadily as the Fed lowered interest rates in 2024 and 2025 and then held policy rates steady for the subsequent nine months. The Fed’s decision to raise rates this month altered the landscape. The inflationary pressures created by rising global energy prices and the ongoing resilience in the U.S. economy compelled the Fed to change its rhetoric and (potentially) course. The market is currently projecting the Fed to deliver 3 or 4 more 0.25% rate hikes by the end of 2027. This is a dramatic market reversal of Fed expectations relative to the beginning of the year when the Fed was expected to continue easing policy gradually.

The Fed’s difficult balancing act

This shift reflects the reality that inflation risks remain present despite remarkably resilient economic activity. Labor markets appear stable, consumers continue to spend, and artificial intelligence (AI)-related capital investment remains an important source of economic support. For the Fed policymakers, this creates a difficult balancing act of maintaining economic momentum while addressing the inflation threat.

Like many central banks, the Fed was compelled to respond to oil-induced inflation. Still, a more inflation-focused Fed doesn’t necessarily imply the beginning of an aggressive hiking cycle. In our view, the path of Fed rate hikes is likely to be shallower than the market fears, particularly since the primary inflation driver is supply-driven energy shocks, which Fed rate policy is ill-suited to address. Reopening the Strait of Hormuz to commercial shipping traffic would calm global markets and likely result in a sharp decline in crude oil prices, which would dramatically ease the Fed’s urgency to combat inflation. However, such a resolution remains elusive, complicating the inflation outlook. But the Fed also values keeping inflation expectations anchored, which are very difficult to stabilize should they become unmoored. We believe this is a primary factor for the Fed’s hawkishness over the past few months.

Overly restrictive monetary policy slowing economic activity more than desired is a rising risk. As of now, the economy is on firm footing, we see further growth next year, and suspect the U.S. can absorb current, or even modestly higher, rates. However, higher borrowing costs work through the economy with a lag. In our view, the flattening curve reflects this tension: confidence that the Fed will ultimately tame inflation, but potentially at the cost of slower growth over the next couple of years if inflation fears compel the Fed to tighten policy by a greater degree than we anticipate.

Ultimately, the U.S. economy continues to plod through the uncertainty caused by the Iran War and the subsequent spike in gasoline prices. Important drivers – such as AI-led tech investment – have taken the baton as a key growth engine. Yet, growth feels uneven given volatile gasoline prices and a lack of sustained hiring.

The AI question

AI-related capital expenditures have become a meaningful contributor to U.S. economic growth over the past several years. While our base case assumes this investment cycle remains intact, some are questioning whether the pace of spending can be sustained indefinitely.

Any moderation in AI-related investment would impact an important pillar of support for economic growth, increasing sensitivity to restrictive monetary policy and reinforcing concerns about longer-term growth prospects. On the margin, these questions may be contributing to the recent yield curve flattening. However, we believe the AI buildout is still in its early stages and will continue to provide a formidable source of economic growth for years to come.

Portfolio implications

We generally remain focused on high quality but also seeing broader opportunities in high yield from a total return perspective with these yields approaching 8%.

Despite increased interest rate volatility and shifting Fed expectations, today's core fixed income yields generate compelling levels of income. Additionally, the market's growth concerns create a supportive environment for high-quality duration should economic activity moderate.

Within high-quality fixed income, we continue to prefer the 3- to 10-year portion of the yield curve. Intermediate maturities offer a balanced risk/reward profile, providing attractive income and moderate interest rate exposure. In addition, intermediate bonds retain enough duration exposure to benefit if geopolitical tensions ease, shipping traffic normalizes, inflation risks fade, and oil prices fall.

Investment grade bond yields remain attractive on both an absolute basis and relative to inflation. This creates a constructive forward-looking total return outlook over a multi-year period. Historically, more than 80% of long-run bond returns have been driven by starting yields, not fluctuations in interest rates. Thus, we believe high-quality fixed income remains well-positioned to serve as both a source of income generation and portfolio ballast for longer-term investment horizons.

Bottom line

The rapid flattening of the Treasury yield curve reflects concerns that restrictive Fed policy could eventually slow growth. While persistent inflation concerns have pushed yields steadily higher, well-anchored inflation expectations have kept the rise orderly. In our view, today’s yield curve suggests the market believes the economy can withstand higher rates for now, but it remains skeptical that it can do so indefinitely.