Key Drivers of Bond Cut-Off Yields

The yield on the 10-year government bond fell sharply to 10.48% in yesterday’s primary auction, down from 12.35% in the previous auction held in June. This significant drop in yield translates to roughly a 12% increase in bond prices. Many investors had been anticipating a decline in inflation, given the central bank’s continued tight monetary stance. As both inflation and inflation expectations begin to ease and the exchange rate stabilizes, market participants expect the central bank to eventually cut policy rates. Bond yields typically fall in anticipation of such macroeconomic stability. But what explains the sudden and steep drop this time? Here’s what I think. It appears that many investors, particularly some large banks, had been waiting for the right moment to take large positions in government bonds. July seemed like the ideal time, as they expected yields to start declining only after the government’s peak borrowing period in June. As a result, several major players moved to take positions in the same auction in July—driving the yield down sharply. The lesson here is clear: trying to perfectly time the market bottom can be costly. Investors are better off positioning early when fundamentals begin to shift.

One of the biggest misconceptions in markets is that when the Federal Reserve cuts rates, bond yields automatically fall. The data tells us otherwise. Last year, the Fed cut its policy rate by 100bps. Yet, instead of declining, 10-year Treasury yields rose by 120bps. This disconnect highlights a fundamental truth: the Fed controls the short end of the curve, but longer-term yields are driven by broader forces — growth expectations, inflation dynamics, fiscal policy, and global demand for U.S. debt. For investors and businesses, the lesson is clear: lower Fed rates do not always translate into cheaper borrowing costs or higher bond valuations. Mortgage rates, corporate financing conditions, and government borrowing costs often move to the rhythm of the bond market, not the Fed. In today’s environment of persistent fiscal deficits, heavy Treasury issuance, and sticky inflation expectations, the bond market is asserting its independence more forcefully. The Fed may set the policy rate, but it cannot dictate how markets price long-term risk. For portfolio managers, this means risk management and allocation decisions must go beyond simply forecasting Fed moves. For policymakers, it is a reminder that credibility and fiscal anchors are just as critical as monetary policy in shaping financial conditions. Graph source: Bloomberg

Use this simple approach to master the Bond Market. Nominal bond yields can be thought of as the interaction between: 1️⃣ Growth expectations 2️⃣ Inflation expectations 3️⃣ Term premium 1. Growth expectations When it comes to economic growth we must consider two angles: structural and cyclical growth. Structural economic growth can be generated through more people joining the labor force (good demographics) and/or through a more productive use of labor and capital (strong productivity trends). The ability of an economy to generate structural growth is an important driver behind long-dated bond yields (strong structural growth = structurally higher long-dated yields and vice versa). Short-term economic cycles also matter for bond yields and particularly at the short-end. Cyclical growth trends are driven by the credit cycle, the fiscal stance, earnings growth, labor market trends and more - the healthier they are, the higher short-end bond yields can be pushed also as a result of a likely tightening from Central Banks that might grow worried about economic over-heating and inflationary pressures in such an environment. 2. Inflation expectations The second component driving nominal bond yields is inflation: but NOT TODAY'S inflation - instead we are referring to long-term inflation expectations. Central Banks might temporarily react to concentrated bursts of inflationary pressures by raising short-term interest rates but when it comes to long-dated bond yields investors will always pay close attention to inflation expectations. That's because consumers and borrowers will tend to make important decisions based on these rather than on volatile short-term trends in inflation. 3. Term premium An investor looking to get fixed income exposure can do that via buying 3-month T-Bills and rolling them each time they mature for the next 10 years. Alternatively, it can decide to purchase 10-year Treasuries today. What's the difference? Interest rate risk! Buying a 10-year bond today rather than rolling T-Bills for the next 10 years exposes investors to risks – term premium compensates for this risk. The lower the uncertainty about growth and inflation down the road, the lower the term premium and vice versa. 💡 The Main Takeaway 💡 If you want to make sense of bond yields, a useful approach to use is to think of them as the result of growth expectations, inflation expectations and term premium. P.S. If you liked this post you'll love my macro research. I share my macro analysis every day with the biggest institutional investors and hedge funds in the world. Get your FREE trial here👇🏼 https://lnkd.in/dyFFJp-z

Goldman Sachs Asset Management Fixed income musings Market Movements ➡️ Bond yields across advanced economies have risen despite central bank rate cuts ➡️10-year government bond yields have drifted higher since December Fed meeting ➡️Movement has been steady rather than sudden, reflecting economic fundamentals Key Drivers ➡️Upward revisions to US growth forecasts due to strong economic signals ➡️Higher inflation forecasts due to tariffs and economic strength ➡️Fed guidance for slower easing pace (two cuts vs four projected) ➡️Fiscal position concerns affecting long-term yields ➡️Technical factors like high bond supply early in year ➡️Country-specific issues (e.g., UK stagflation fears) Investment Implications ➡️Fixed income spread sectors remain resilient ➡️Focus on fundamentals as economy deviates from historical patterns ➡️Expect volatility from US policy changes under Trump administration ➡️Global opportunities exist outside US markets Need to stay agile and adjust exposures based on evolving dynamics Central Bank Outlook ➡️Fed: Expected rate 3.75-4% by end-2025 ➡️ECB: Moving toward 1.5% terminal rate ➡️BoE: Multiple cuts expected, targeting 3.5% ➡️BoJ: Further hikes likely, reaching 1% by end-2025

Yields framework and investors mantra 10 year US Treasury yield is currently at 4.42, it was 3.62 in mid september. This was just after the Fed delivered a jumbo cut of 50 bps on the overnight fed fund target rate. Lets try to see what is behind the rise of yields and which are the actors responsible. The long term rates in any economy are not completely in the control of the Central bank. CB at best can alter the short term rates while the long term yields are determined by the market participants by selling or buying the bonds in that maturity bucket. CB at best can be one participant among many in that buying and selling. Like the QE policy when Fed decided to buy the long term bonds and keep the rates low. However the more QE you do, you will defile the market dynamics more and the market will become increasingly aloof to fundamentals. From a long term perspective this is not desirable. The urge to control has to be reigned in. That is why the QE policies are publicly announced and their sunset clauses are also communicated in detail. Now when an investor is thinking about long term lending, they will take multiple factors into account. Firstly will be the path of short term rates by the Fed, secondly will be how the future inflation and growth dynamics would play out, then comes the estimation of future supply and demand dynamics and last but not the least a deep thought on how volatile the above estimates are. It is one thing to forecast but it is equally important to account for the eventual misfire. Volatility demands its own price. The longer tenor forecast it is, the likelier it is expected to astray from estimates. This in common jargon is known as the term premium. While the estimates of Fed future path have remained mostly on track other factors have changed. The fiscal path to be taken by the new administration is not clear. More fiscal deficit means more bond issuance, meaning more supply and higher yields. Then comes the demand side. The demand is generated by long term investors like pension funds, banks (BASEL requirements), Fed purchases (QE) and the other Central banks. Other Central banks buy USTs because they are gaining dollars by running trade surpluses with US. These dollars are invested back in US, generating demand for US bonds and hence lowering its yield, in effect making US govt borrow at cheaper cost. However with the impending tussle with trading partners, it is likely that their dollar pile goes down and hence the demand for USTs. The tariff induced goods inflation and anti immigration induced wage inflation are also keeping the yields up but the biggest factor again is the uncertainty. Trump's approach for quick and sudden decisions ultimately make the markets wary of any long term commitment. This makes investing in a longer duration asset a bad choice. Keep it short and keep it safe, thats the mantra.