The U.S. Treasury market has recently experienced a wave of rapid buying, causing the yields of 2-, 10-, and 30-year Treasury bonds to fall to varying degrees. Combined with the fact that U.S. labor data has repeatedly fallen short of expectations and concerns about inflation brought about by the trade war, the market previously favored trading U.S. stagflation, that is, going long on short-term U.S. Treasury bonds and shorting long-term Treasury bonds to make a profit (because short-term Treasury bond yields are sensitive to interest rates, while long-term Treasury bond yields are sensitive to inflation). Although Treasury bond yields have all fallen, the steepening of the yield curve has not changed. However, this most mainstream trading strategy in the U.S. Treasury market is facing a test recently, and it has also laid the groundwork for the Federal Reserve's interest rate decision to exceed expectations.

The US Treasury bond market, which is worth $29 trillion, is experiencing a fierce tug-of-war

In this market, a tug-of-war between two types of one-way investors has emerged: one type is worried that cracks in the labor market may prompt the Federal Reserve to cut interest rates sharply, so they go long on Treasury bonds; the other type is worried that the Fed's anti-inflation process has not yet been completed, so they sell Treasury bonds.

At the beginning of last week, this benchmark yield briefly fell below the key psychological level of 4%, but the recent rebound of the 10-year U.S. Treasury yield to above 4% just confirms the above tug-of-war situation.

On Monday afternoon, the 10-year U.S. Treasury yield was 4.034%. This data shows that in the face of relatively low yields this year, investors are still hesitant to allocate long-term U.S. Treasury bonds.

Investors remained cautious ahead of the Federal Reserve's two-day policy meeting, which will conclude early Thursday morning Beijing time. Chairman Jerome Powell is expected to announce a 25 basis point cut in short-term interest rates and release an updated economic outlook.

“A lot of investors are reluctant to buy the dip — to buy more bonds when yields are falling,” said Gennady Goldberg, head of U.S. rates strategy at TD Securities. Bond prices and yields move inversely.

Despite increased volatility in the U.S. Treasury market this year, Treasury yields are generally on a downward trend compared to six months ago. The decline in the 2-year Treasury yield is much greater than that of the 10-year Treasury yield. However, this isn't the only trading trend worth noting in the Treasury market.

Steep trading strategies thrive

Among bond fund managers, a very mainstream trading strategy is to bet on a "steepening" of the U.S. Treasury yield curve - that is, a widening of the gap between short-end and long-end U.S. Treasury yields.

This strategy has been effective recently: a few weeks ago, the yield spread between 10-year and 2-year Treasury bonds hit 65 basis points, the second highest level since January 2022, only lower than the level of 67 basis points when the spread briefly surged during the tariff shock in April.

Kent Engelke, chief economic strategist at Capitol Securities Management, is among those who believe in a steepening yield curve.

"Based on multiple factors, I am convinced that the yield curve will steepen," Engelke said. He pointed out that continued upward inflation, the huge US fiscal deficit, and the Trump administration's attack on the Federal Reserve's independence are all core driving factors.

Steep trading strategies are risky, as the Fed's interest rate decision could reverse

Royal Bank of Canada (RBC) strategists accurately predicted in early September that investors betting on a steepening U.S. Treasury yield curve might face a "pain trade" before the Federal Reserve's interest rate decision. The yield curve's steepening momentum has recently slowed slightly.

Simon Dangoor, head of fixed income macro strategy at Goldman Sachs Asset Management, believes the Fed may launch a series of "adjustment rate cuts" but will not be forced to launch emergency response measures due to a significant increase in recession risks.

Specifically, he still expects the U.S. economy to achieve a soft landing despite recent cracks in the labor market. "The current environment is relatively favorable for investors who bet on a steepening yield curve," Dangur said, but he also believes that the subsequent trend "has become more complicated."

The S&P 500 (SPX) and the Nasdaq Composite (COMP) hit record highs on Monday, driven by market expectations that the Federal Reserve may boost the stock market while cutting interest rates and help the economy achieve a soft landing.

Amar Reganti, fixed income strategist at Hartford Funds, said the Fed currently appears more focused on labor market cracks than inflationary pressures, but he also believes it is too early to tell what impact tariffs might have on inflation.

“I think the market’s mistake is assuming that the tariff costs will be passed through to prices all at once,” Reganti said of the tariff costs. “We’ve always believed that this is a nonlinear process — it could be passed through quickly, it could be passed through slowly, or it could not be passed through at all.”

Judging from the yield curve, the above claim is verified. Since the 10-year Treasury yield = the Federal Reserve's benchmark interest rate + inflation expectations , the US 10-year yield and 2-year yield are both falling rapidly, indicating that the market is digesting the Fed's interest rate cut expectations or that the market is suppressing the Fed's inevitable interest rate cut.

However, the difference between the yields of U.S. 2-year and 10-year Treasury bonds is becoming larger, making the yield curve steeper, and the decline rate of the 10-year Treasury bond yield is slowing down rapidly, which means that traders' concerns about inflation require the 10-year Treasury bond to provide a higher yield.

Since the U.S. 10-year Treasury yield is sensitive to inflation, and the U.S. PPI and CPI data do not provide clues that inflation will continue to intensify, the effect of U.S. tariffs on inflation transmission is unknown.

Based on the above logic, we can deduce that the core factor currently supporting the steepening yield curve—high inflation expectations—lacks solid data support. In the future, a decline in inflation expectations (even if only to normal levels) could trigger a flattening of the Treasury yield curve. The transmission path is as follows: Declining inflation expectations would directly depress the more inflation-sensitive 10-year Treasury yield, accelerating its downward trend and narrowing the yield spread over the 2-year Treasury bond.

Traders should be particularly aware that this flattening risk may intensify: if the inflation data not only fails to rise but is lower than expected, it will have a severe impact on market sentiment, causing the 10-year yield to fall sharply due to the collapse of inflation expectations. At that time, the speed and magnitude of the curve flattening will far exceed expectations.

Another market narrative is that the recent rapid decline in 10-year yields may itself be a reflection of the market's "cooling inflation expectations." If subsequent data (such as CPI) continue to demonstrate that tariffs have not effectively boosted inflation, then even if the Fed chooses not to cut interest rates for now to preserve its independence, the 10-year yield could continue to decline independently, driven by expectations of easing. In this scenario, the flattening of the yield curve would be the result of natural market forces, not Fed policy.

In short, the trend in the 10-year yield provides the Fed with a buffer. The market's spontaneous "easing trade" (reflected in falling long-term interest rates) has, to some extent, replaced the urgency of the Fed's rate cuts. This buys Powell time, allowing him to wait for more reliable data before making a decision, thereby avoiding being "held hostage" by market expectations and better safeguarding the Fed's policy independence.