How Bond Markets React to Rate Cuts By Jim Reber, President and CEO, ICBA Securities, MIBA Endorsed Vendor In just a few short weeks, the fixed-income market’s expectations for monetary policy have done a virtual about-face. This is not to say that investors are fickle. Some of this change in sentiment is data-driven, some is the Trump administration officials’ cajoling, and some is Federal Reserve Board Chairman Jay Powell’s comments in Jackson Hole, Wyoming, on Aug. 22. Regardless, market indicators have shifted from zero or one rate cuts for the rest of 2025, to as many as four. Sept. 17 will possibly be a watershed day for Fed-watchers’ expectations. Not only will we see if the Federal Open Market Committee resumes its rate-cutting, which has been on hold since last December, but we will also get an update to its quarterly Summary of Economic Projections (SEP). Since the July labor reports indicated job growth was much weaker than initially reported, the chorus for rate cuts has gone from a murmur to a roar. It's Been a Minute The last time the Fed cut rates was way back in March 2020. Veteran bankers will recall that at the outset of the COVID-19 pandemic, our central bank began injecting massive amounts of stimulus into the U.S. economy. These efforts included rate cutting, huge amounts of bond buying and market support initiatives like the Municipal Lending Facility, which backstopped states, cities and other local borrowers. These efforts were broadly successful, and liquidity in debt markets quickly returned to normal. “Normal” in this context refers to credit spreads, which are the incremental returns over and above a risk-free rate. All debt instruments will have more yield than a similar maturity Treasury bond as they have some aspects that are less safe, however minor. The widening and narrowing of these yield spreads is an indication of how much relative risk is being priced into the bond market. When rate cutting starts, there usually are two reactions by bond market investors that are predictable, viewable and significant. Follow the Leader The first is that fixed-rate investments will track overnight rates with varying degrees of correlation based on maturity. Two-year Treasury bond yields will change about 80% as much as the fed funds rate, while 10-year bond yields will move only about 45% as much. Note that this is over time, and not immediate; in fact, Treasury yields can react to a rate cut much earlier than the actual event. For example, the two-year note has yielded less than fed funds since March 2023; the long-term difference in yield is around plus-40 basis points (0.40%). This is a clear indication that the market anticipates the next move by the Fed will be to lower, not raise, rates. What this also implies is that the shape of the curve is expected to steepen. On Your Marks 22 | The Show-Me Banker Magazine
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