Tariffs "stir up," U.S. Treasury yields become more differentiated, making it harder for the Federal Reserve to cut interest rates!

Despite the rebound in the U.S. stock market following the initial turmoil triggered by Trump's tariff statements, the bond market remains plagued by ongoing "troubles."

Currently, the core issue in the U.S. Treasury market is the significant divergence in the yield trends between short-term and long-term bonds. Short-term Treasury yields have declined amid market expectations for a Federal Reserve rate cut, while long-term Treasury yields, which are a key benchmark for economic financing costs, have risen instead of falling.

Data shows that since April 2, the benchmark 10-year U.S. Treasury yield has climbed to about 4.38%, while short-term U.S. Treasury yields are decreasing.

This rare yield divergence not only directly raises borrowing costs for consumers and businesses but, more critically, poses a severe challenge to the Federal Reserve's traditional policy path of stimulating economic growth through rate cuts.

Drivers Behind Yield Divergence

The primary reason for this divergence is the uncertainty surrounding inflation.

While investors believe that inflation and interest rates will decline in the coming years, Trump's erratic trade policies have reduced the certainty of these predictions.

As a result, investors demand higher yields to compensate for the risks of holding long-term Treasuries—this additional compensation is known as the "term premium." Tim Ng, a fixed income portfolio manager at Capital Group, stated that the bond market reflects "uncertainty about the economic direction and ongoing concerns about policy prospects."

Investor hesitation in purchasing long-term Treasuries also stems from worries that the growing financing needs of the federal budget deficit will harm bond prices.

Analysts point out that Republican lawmakers in the House and Senate have been preparing significant tax cut legislation for months, which may or may not include substantial spending cuts.

Impact on Federal Reserve Policy and the Economy

Most investors and analysts believe that if the U.S. falls into recession this year and the Federal Reserve significantly cuts rates, long-term yields should theoretically decline.

However, the concern is that they may not fall much, keeping mortgage rates and other types of debt high when the central bank hopes to encourage borrowing.

According to data from Freddie Mac, the average rate for a 30-year fixed mortgage last week was 6.8%, slightly up from a month ago.

The term premium can only be estimated, but by various measures, it had already risen before Trump's tariff announcement in April. Most models indicate that the term premium increased when high inflation unexpectedly re-emerged in 2021. There was another spike after Trump's election in November last year, as investors bet that his policies could drive up inflation and deficits.

The announcement of tariff policies triggered a broad sell-off in markets, including Treasuries. Although yields have declined somewhat after the Trump administration took steps to soften some policies, the term premium remains elevated across various models.

Goldman Sachs analysts wrote in a recent report:

"The reset of the term premium will be difficult to reverse... potential macro uncertainties... may not be resolved simply by a change in rhetoric."

Cautious Response from Policymakers

The increased volatility in demand from long-term government bond investors means that officials need to act cautiously when formulating monetary and fiscal policies.

At last week's press conference, Federal Reserve Chairman Jerome Powell repeatedly stated that the central bank is not in a hurry to cut interest rates, citing that economic data remains robust, but there is also the risk of inflation potentially rising again.

Chris Brown, head of securitized products at T. Rowe Price, interpreted this move by the Federal Reserve as primarily aimed at "striving to establish and firmly maintain its hard-won credibility in fighting inflation."

Meanwhile, the U.S. Treasury has also shown an increasing sensitivity to market conditions when formulating government debt issuance strategies.

For instance, in 2023, to meet the growing borrowing demand, the Treasury had at one point increased the auction size of long-term bonds. However, after observing that this move led to a significant spike in long-term yields, they quickly slowed down the pace of issuance, a adjustment that helped to gradually calm the market. Notably, current Treasury Secretary Scott Bessent publicly criticized the Treasury during the presidential campaign for failing to issue more long-term debt to lock in low interest rates.

However, his statements after taking office indicate that there are no plans to adjust the current auction size in the foreseeable future, reflecting the complexity of the current decision-making environment from one perspective.

Historically, a sustained rise in term premiums may be manageable for the economy. From most indicators, in the 1980s and 1990s, the term premiums in the U.S. were generally higher than current levels, while investors were still immersed in the memories of the inflation of the 1970s, and economic growth remained strong for much of that period.

However, unlike back then, the current volatility in demand for long-term U.S. government bonds has significantly increased, which means that policymakers need to be more cautious when adjusting policies. The divergence between short-term and long-term yields not only raises borrowing costs for consumers but also limits the Federal Reserve's ability to stimulate the economy through interest rate cuts.

This divergence complicates the Federal Reserve's task of balancing inflation control and economic growth, further increasing the difficulty of achieving a soft landing for the economy