Fed Cuts Interest Rates, But US, Europe, and Japan Bond Yields Rise in Unprecedented Reversal

Global bond yields rise despite Fed's interest rate cuts, driven by growing fiscal deficits and Trump's policy risks

Despite the Federal Reserve's recent interest rate cuts, bond yields in the United States, Europe, and Japan have been rising, creating a perplexing economic anomaly. Generally, when central banks lower their benchmark interest rates, it is expected that market interest rates would also decrease, easing the financial burden on households, businesses, and governments. However, the opposite is currently happening, as bond yields are climbing, making borrowing more expensive. This increase in yields is largely attributed to concerns over rising fiscal deficits and heightened global economic uncertainty following the potential return of US President Donald Trump. The surge in US Treasury bond yields, in particular, is influencing other market interest rates, including domestic bank bonds and mortgage rates, leading to higher borrowing costs despite the Fed's monetary easing.

Rising Bond Yields Despite Interest Rate Cuts: A Complex Global Trend

Normally, there is a strong correlation between central bank interest rates and bond yields. When the central bank lowers rates, borrowing costs fall, prompting increased demand for bonds as safer investment assets. This demand drives bond prices higher and yields lower. However, the current situation shows a stark contrast: bond yields are rising even as the Fed cuts rates. The US 10-year Treasury bond yield surged to 4.8090% on January 14, its highest level in over a year. This rise comes even after the Fed began lowering its benchmark rates by 0.50 percentage points in September 2024, marking the first rate cut in four and a half years. Throughout 2024, as the Fed reduced rates by 1%, the 10-year US Treasury yield increased by more than 1%, showing a clear disconnect between the Fed's actions and bond market behavior.

The surge in US bond yields has created a ripple effect, leading to similar increases in bond yields worldwide. The UK’s 10-year bond yield rose to 4.823% in early February, its highest level since 2008. Similarly, Germany’s 10-year bond yield reached 2.568%, the highest since July 2024, and Japan’s 10-year yield surged to 1.196%, the highest in 14 years. These rising bond yields are contributing to a general increase in market interest rates, which, despite the Fed's rate cuts, have led to higher mortgage rates in the US, approaching 7%.

Fiscal Deficits and Trump’s Policy Risks Drive Higher Bond Yields

The unexpected rise in bond yields amid Fed rate cuts is largely driven by concerns over rising fiscal deficits and the potential return of Donald Trump to the presidency. These two factors are contributing to increased market uncertainty, which, in turn, is pushing bond yields higher due to what is known as the "term premium." The term premium refers to the additional yield that investors demand for holding longer-term bonds, such as the 10-year Treasury, in times of uncertainty. As economic and political risks increase, investors require higher returns on long-term investments, driving up bond yields.

The global fiscal landscape is also playing a significant role in pushing bond yields higher. With many countries grappling with ballooning fiscal deficits, there are expectations that these governments will issue more bonds to finance their deficits. An increase in bond issuance raises the supply of bonds in the market, which tends to push prices down and yields up. In particular, fears of worsening fiscal conditions are diminishing demand for government bonds, as investors worry about the long-term stability of the issuing countries' finances. According to economists, the G7 nations are expected to run fiscal deficits averaging 6% of their GDP in 2025. The US, in particular, is projected to issue up to $2 trillion in bonds this year, equal to around 7% of its GDP, to cover its fiscal gap.

The situation is further exacerbated by Trump’s proposed economic policies, which include stricter immigration controls, tariffs, and further tax cuts. These policies are expected to increase inflation, as a reduction in low-wage immigrant labor and higher import prices could push prices up. This could, in turn, lead the Fed to reconsider its stance on interest rates, potentially reversing its current rate-cutting policy. Moreover, Trump’s past tax cuts, including a reduction in the corporate tax rate from 35% to 21%, with plans to cut it further to 15%, have significantly reduced government revenue, making it more reliant on issuing new bonds to fund the deficit, thus contributing to rising bond yields.

Projections for US Bond Yields and Long-Term Impact

Market analysts predict that US bond yields are likely to continue rising in the near future. ING, a global financial institution, forecasts that the yield on the US 10-year Treasury bond could reach 5.5% by the end of 2025. Gregory Peters, the Co-CIO of fixed income at US asset management firm GIM, stated that a breach of the 5% mark for the US 10-year Treasury bond yield would not be surprising. Some market experts, including Julien Brizeau of Macro Intelligence 2 Partners, predict that the US 10-year bond yield could rise to as high as 8% by 2050, highlighting the long-term upward trend in bond yields.

US Treasury Secretary Scott Vesent recently commented that while both he and President Trump are focused on reducing the 10-year Treasury bond yield, they are not calling for a rate cut by the Fed. He argued that regulatory changes aimed at boosting private investment would ultimately help resolve issues related to high bond yields and other economic concerns.

In summary, while the Fed has reduced interest rates to stimulate economic growth, the global bond market is responding with rising yields. This paradox is driven by a combination of fiscal deficits, economic uncertainty, and policy risks, particularly stemming from potential changes in US leadership. As governments increase bond issuance to finance deficits, and as inflationary pressures mount, bond yields are likely to remain elevated, keeping borrowing costs high despite the Fed’s monetary easing.