Unpredictable 10-Year Treasury Yield Poses Puzzle for Investors, Fed

Recent declines in critical borrowing benchmark have come despite expectations for higher shortterm interest rates

One question looming over the Federal Reserve’s meeting this week: How much control do officials have over the all-important yield on the 10-year U.S. Treasury note? Fed officials have already sent clear signals that they plan to raise their benchmark federal-funds rate by 0.5 percentage point when they conclude their two-day meeting on Wednesday. What happens to the 10-year Treasury yield, though, is far less certain—especially in light of its surprising recent declines.

Yields on longer-term Treasurys like the 10-year note play a critical role in the U.S. economy by setting a floor on borrowing costs for businesses and consumers. Because bond yields are largely determined by investors’ expectations for shortterm interest rates over the life of a bond, the Fed can influence them by changing the level of short-term rates or projecting what those rates will be over the next couple of years.

Still, recent weeks have shown how unpredictable the 10-year yield can be. Over that time, Fed officials, including Fed Chair Jerome Powell, have signaled that they are likely to raise the fed-funds rate a little higher than they had previously projected in their last official forecast made in September. Even so, the 10-year yield settled at 3.501% Tuesday.

That was down more than 0.7 percentage point from its recent peak in early November, and also down from 3.611% Monday after a lower-than-anticipated monthly inflation reading. It was down even further, to 3.508%, early Tuesday after the Labor Department released weaker-than-expected consumer-price index data. Highlighting the confusion, some investors said that they could get advance notice of the Fed’s messaging this week and still have a hard time predicting how the 10year Treasury yield would respond.

Their rationale: if the Fed sends a so-called hawkish message, emphasizing concerns about inflation and projecting higher interest rates than expected, the 10year yield could climb, as investors expect higher rates for longer. Then again, it could fall, if investors think that higher short-term rates alone could be enough to choke off the economy, forcing the Fed to quickly reverse course and start rapidly cutting rates next year. Already, longer-term yields are well below that of shorter-term yields in what is known on Wall Street as an inverted yield curve, noted Donald Ellenberger, a senior portfolio manager at Federated Hermes.

“The problem is the more hawkish Powell sounds in the face of inflation on the downswing and rising recession risks, the more the yield curve inverts,” he said. “Powell can push up shortterm rates, but it’s getting increasingly difficult for him to push up long-term rates.” Falling long-term bond yields are important in part because they could make it harder for the Fed to bring inflation back to its 2% annual target. Mr. Powell has pointed out repeatedly this year how investors’ rising expectations for short-term interest rates—as reflected in higher bond yields—have done more to fight inflation than the actual increases in the fed-funds rate.

At times this year, Mr. Powell and other Fed officials have actively tried to push back against the market when yields have declined— though it isn’t clear if they see the most recent decline as a problem.

One question that could determine where the 10-year yield goes from here is whether there is a limit to how far it can fall below yields on shorter-term Treasurys, like the two-year note. Regardless of their baseline interest-rate expectations, investors generally like to get some extra compensation for holding bonds over a longer time period to guard against the risk of unexpected inflation and interest-rate increases.

For months, the 10-year yield repeatedly failed to drop more than 0.5 percentage point below the two-year yield. More recently, though, it has blown past that barrier, falling as much as 0.85 percentage point below the twoyear yield—the largest such gap in more than four decades.

Some analysts point to the Fed’s apparent decision to slow the pace of rate increases as one reason longerterm yields have fallen recently. Officials, in recent weeks, have indicated that they will raise rates in smaller increments going forward—to guard against the risk of causing an unnecessarily severe recession—while at the same time stressing their intention to keep going next year.

For a time, investors seemed to assign equal weight to both parts of that message. Subsequently, though, they have put more emphasis on the central bank’s near-term policy shift, which some see as confirmation that the Fed shares their view that inflation is easing and recession risks are rising.

Fed officials have “already in my mind exhausted this topic of leaving rates higher,” said Blake Gwinn, head of U.S. interest rates strategy at RBC Capital Markets. “Anything the Fed’s telling us about something that’s more than six months out, we basically just kind of shrug off.” Nonetheless, some analysts make the point that the Fed’s direct control over short-term interest rates still gives it significant sway over longerterm rates.

If the yield curve inverts further, the Fed, if it wants to, should be able to drive up longer-term yields by raising short-term rates even higher, they say. The process would just take longer than it would if investors were more willing to accept the Fed’s projections.

The Fed’s ability to raise short-term rates gives it “the whip hand here,” said William Dudley, the former New York Fed president who was also previously chief U.S. economist at Goldman Sachs. “Markets can be more optimistic or more pessimistic, but the Fed ultimately writes the story.”