Fed rate cuts will reduce short-term yields, but less impact on long-term yields

Key Takeaways

• The anticipated resumption of Federal Reserve (Fed) rate cuts this year should lower short-dated yields (i.e., 0- to 2-year maturities). However, concerns over the U.S. deficit, debt levels, and trade imbalances are likely to limit how far yields can decline beyond 2-year maturities.
• Fed policymakers are navigating a delicate balance. While recent labor and inflation data support the case for a rate cut in September, market participants will be watching closely for signs of Fed independence and a sustained commitment to controlling inflation, which remains above target.

Labor and inflation data support Fed easing

• The July unemployment report surprised markets. Revisions to the prior two months’ payroll gains subtracted 258,000 jobs, and July hiring fell short of expectations. As a result, traders sharply increased the probability of a September rate cut—from roughly 40% to nearly 90%.
• The latest CPI inflation report, which aligned with expectations, further reinforced the likelihood of near-term Fed easing. However, there is a packed economic data calendar between now and the next Fed meeting.

Base case: 50-basis points (0.5%) of cuts by year end

• Our base case anticipates a total of 50-basis points (0.50%) in Fed rate cuts by year-end, beginning with a 25-basis point (0.25%) reduction at the September meeting.

• Uncertainty around tariffs and their impact on inflation, along with potential distortions in corporate hiring, suggest the Fed will proceed cautiously.

• However, even if the Fed lowers the federal funds rate—closely tied to very short-dated yields—longer-term yields (beyond two years) may not decline in tandem.

• We expect yields across the curve to fall during the next phase of the easing cycle, though yields beyond 2-year maturities may prove somewhat "stickier" than the very front end of the yield curve.

Term premia likely to remain elevated

• Term premia represent the additional compensation investors demand for bearing uncertainty over longer investment horizons.

• Currently, 10-year term premia remain near their highest levels in a decade, reflecting persistent macroeconomic uncertainty and investor caution.

In a typical Fed rate cut cycle, yields across the curve tend to decline. That is especially true in the first 2 years of the yield curve where rates are much more sensitive to the central bank’s policy decisions. Assuming the Fed resumes lowering rates, it is likely to be in the context of slower U.S. growth, a cooler labor market, and tolerable inflation – all which are consistent with lower intermediate and long-dated yields. These factors should apply downward pressure on longer-dated yields; however, their declines may be hampered by term premia staying high. This should result in a steeper yield curve. Additionally, if the Fed cuts rates aggressively, it could raise the market’s collective eyebrows about its commitment to keeping inflation on a downward trajectory. The Fed will be performing a very difficult balancing act. 

Bottom line

Short-dated yields are expected to fall over the next 12–18 months as the Federal Reserve resumes rate cuts. However, yields beyond 2-year maturities may decline more gradually due to persistent uncertainty around trade and fiscal policy, which could dampen the broader impact of Fed easing.