U.S. Treasuries have already "spoiled" the surprise? Inflation may once again become the Federal Reserve's top priority!

The market expects the Federal Reserve to lower the benchmark federal funds rate by 25 basis points to a range of 4.5% to 4.75% on Thursday local time. The key question is, how much more can the Federal Reserve lower rates during this easing cycle?

The bond market indicates that the extent of the rate cuts may not be as large as some expect, nor as significant as policymakers hinted at two months ago.

Although the two-year U.S. Treasury yield tracks the federal funds rate, it often anticipates the Federal Reserve's actions. Historically, it has been a good predictor of the Fed's moves. Recently, in 2021, it signaled that the Fed would raise rates months before policymakers took action to combat inflation. It also began to decline a few months before the Fed started easing policies in September.

However, the two-year U.S. Treasury yield has recently changed its mind—not about the direction of rate cuts, but about their magnitude.

A little over a month ago, the two-year U.S. Treasury yield was around 3.5%, supporting the market's general belief that the Fed was moving toward a so-called terminal rate—typically understood as 0.5 to 1 percentage point above its 2% inflation target. The Fed reinforced this impression in its September economic projections summary, which showed that the median member of its rate-setting committee believed the benchmark rate would fall to 3.4% by the end of next year.

However, in the past few weeks, the two-year U.S. Treasury yield has risen by 70 basis points to 4.2%. This is a significant increase, indicating that the bond market expects the Fed to cut rates two more times after Thursday's cut, each by 25 basis points. This means the federal funds rate would stabilize in the range of 4% to 4.25%.

Why the change?

Interpreting market psychology is difficult, but some recent progress by the Federal Reserve on its dual mandate of maximum employment and price stability is noteworthy. Regarding the former, the economy no longer seems to be sliding into recession and dragging down the labor market. The widespread recession fears of 2022 appear to have been confirmed as the unemployment rate began to rise a year later, peaking at 4.3% in July after a low of 3.4% in April 2023. This has prompted the Fed to give at least as much attention to the labor market as to inflation, ultimately leading to the Fed beginning to cut rates.

However, a recession has not yet occurred. In the second and third quarters, the U.S. economic growth rate, adjusted for inflation, was about 3%, and the Atlanta Fed's GDP tracker estimates this quarter's growth rate at 2.4%. Since July, the unemployment rate has also fallen to 4.1%, despite some monthly employment data fluctuations during that period.

This may explain why the 10-year U.S. Treasury yield is slightly higher than the two-year yield, thus adjusting the inverted yield curve, which many believe signals recession risks. It turns out that the labor market may not need as much help as previously expected.

Now consider the other side of the Fed's dual mandate. Inflation is rapidly approaching the Fed's 2% target, but achieving this goal may become more difficult after the presidential election. According to the nonpartisan Committee for a Responsible Federal Budget, Trump's spending plan will accumulate a $15 trillion deficit over the next decade This adds a significant amount of fiscal stimulus on top of the total deficit of $11 trillion since 2020, which has fueled the recent rise in consumer prices. Not to mention Trump's promises to expand tariffs or deport illegal immigrants, as well as the size of the Federal Reserve's balance sheet, which has ballooned to $7 trillion—a pile of monetary stimulus that was unimaginable before the COVID-19 pandemic. All of this is a potential driver of inflation.

Other parts of the bond market seem to think so too. The 5-year breakeven rate—the difference between the nominal 5-year U.S. Treasury yield and the inflation-adjusted 5-year U.S. Treasury yield—is a good indicator of inflation expectations and has risen from nearly 1.8% in September to 2.5%. The 10-year breakeven rate reached the Federal Reserve's ideal level of 2% in September, but has since climbed to 2.4%. While these numbers are not far above the Federal Reserve's target, the direction is significant.

A solid economy supported by a large amount of fiscal and monetary stimulus is less likely to be the cause of a weak labor market and more likely to be the reason for inflation rates consistently exceeding the Federal Reserve's target. This may explain why the 2-year U.S. Treasury yield has not seen significant further cuts from the Federal Reserve.

Keep a close eye on the 2-year U.S. Treasury yield. It may reveal the Federal Reserve's direction to investors more than what the Federal Reserve or Powell said on Thursday.