Pressure on Long-End U.S. Treasuries Persists After U.S. PCE Data: 30-Year Yield Approaches 5.2%, Term Spread Widens

The Federal Reserve's decision this week to keep interest rates unchanged continues to stir the bond market. Long-end U.S. Treasury yields remain elevated following the release of the latest economic data, with resilience in inflation and employment causing greater divergence in market judgments on the future path of rate hikes. The steepening yield curve is driving increased safe-haven demand.

After surging more than 10 basis points on Wednesday to its highest level since 2007, the 30-year U.S. Treasury yield held near 5.20% on Thursday.

On Thursday, the U.S. reported that the June PCE price index fell 0.1% month-on-month, marking the first monthly negative growth since 2020. The year-on-year increase narrowed from 4.1% in the previous month to 3.7%. The core PCE, excluding energy, saw its year-on-year growth rate slip slightly from 3.4% to 3.3%, while the month-on-month rise was only 0.1%, below the market expectation of 0.2%.

Additionally, oil prices, which had previously declined in June, rose again after the U.S. resumed military actions against Iran, exacerbating market concerns about supply risks in the Middle East.

Interest rate swap markets indicate that the probability of a 25-basis-point rate hike by the Federal Reserve in September is about two-thirds, lower than the level fully priced in before the previous Fed decision.

Long-End Yields Remain Elevated as Inflation Expectations Surge

Following the Federal Reserve's pause, long-end U.S. Treasury yields have struggled to fall, with market concerns over persistent inflation providing main support.

The 30-year breakeven inflation rate—a measure of market inflation expectations—jumped 6 basis points in a single day on Wednesday, the largest one-day increase since the day after Trump won the presidential election in November 2024.

Oil prices climbed again after the U.S. restarted military strikes against Iran, and uncertainty regarding Middle East supply prospects further reinforced inflation expectations.

Jens Peter Sorensen, Chief Analyst at Danske Bank A/S, stated:

"If inflation does not slow down, there is a risk of further upward movement in long-end bond yields. The market can only guess how many more rate hikes will be needed, and the timing of these hikes may be later than expected."

Short-End Yields Decline, Steepening Trend Continues

In contrast to the long end, short-term U.S. Treasury yields continued to decline on Thursday, with yields on 2-year to 5-year notes each falling about 5 basis points to touch weekly lows.

This movement was partly driven by the UK market—after the Bank of England's monetary policy meeting, UK gilt traders reduced their bets on a September rate hike, dragging down UK bond yields. The yen's gain of over 3% against the U.S. dollar in a single day also supported short-end U.S. Treasury yields.

As a result, key term spreads widened further, returning to highs seen since May: the spread between 2-year and 10-year yields approached 45 basis points, and the spread between 5-year and 30-year yields expanded to 84 basis points, as the yield curve continued to steepen.

Large Capital Bets on Further Rise in Long-End Yields in Options Market

The steepening trend in the yield curve has triggered significant hedging demand in the derivatives market, with investors turning to Treasury options to seek protection against further rises in long-end yields.

On Thursday, a $13 million options trade appeared in the market, betting that the 10-year Treasury yield would rise to 4.80%—last year's high—within a few weeks.

On Wednesday, a massive September options trade targeting Treasury futures emerged, aiming for the 30-year yield to rise to approximately 5.3% within a few weeks. Both of these options expire on August 21.

Fed Credibility Questioned, Uncertainty Surrounds Rate Hike Path

Federal Reserve Chair Walsh's decision to hold rates steady this time has sparked market doubts about his determination to combat inflation, thereby increasing uncertainty regarding the path of rate hikes.

Torsten Slok, Chief Economist at Apollo Global Management, said in an interview:

"We need to discuss the committee's credibility; it cannot remain just talk, but must ultimately be backed by action."

Previously, the market had priced in about a 40% probability of a rate hike at this meeting to demonstrate Walsh's anti-inflation stance, but this expectation failed to materialize. Swap market pricing currently shows a reduced likelihood of a rate hike in September, and the probability of a second rate hike within the year has halved from about 80% previously to around 40%.

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