Treasury Bond Market Faces Policy Tug-of-War

As the second half of the year gets under way, a tug-of-war between monetary and fiscal policies is developing in the Treasury bond market. Monetary policy appears headed toward easing, but ongoing expansive fiscal policies that increase the federal deficit could limit the decline in yields.

With polls showing very close races for presidential and congressional candidates, markets are beginning to focus on policy proposals that could affect the long-run prospects for the economy and budget deficit. It's far too early to make predictions about post-election policies, but we anticipate higher volatility between now and November as uncertainty rises. Long-term Treasury yields and the dollar are likely to feel the biggest impact. Both may remain higher than anticipated.

Monetary policy has tended to be the major driver of interest rates over the long run. When the Federal Reserve sets the target range for the federal funds rate (fed funds) it ripples across the Treasury yield curve, but the impact diminishes as maturities increase. Short-term yields are directly affected by Fed policy. Intermediate- to long-term yields are affected by the outlook for inflation, economic growth, and the supply/demand balance in the market. Long-term yields typically carry a risk premium (or "term premium") to compensate investors for tying up their money for an extended time.

The U.S. has had a combination of tight monetary policy and expansive fiscal policy for the past few years. While the trend in rising budget deficits goes back to the early 2000s amid a combination of tax cuts and increased spending, it accelerated during the pandemic. Consequently, the 2024 fiscal-year deficit is estimated to be 7.0% of gross domestic product (GDP)—an unusually high level for a peacetime economy—and then 6.5% of GDP in 2025. The Congressional Budget Office (CBO) estimates that high deficits will continue if no changes are made.

While we don't believe the U.S. is on the verge of a debt crisis, in the long run, the path of fiscal policy is a concern. To date, the bond market has been sanguine about these prospects, but as November approaches with talk of possible tax cuts and tariffs, jitters are beginning to show. Tariffs are inflationary because they raise the cost of imported goods to consumers, while deeper tax cuts without offsetting expenditure cuts, would increase the deficit.

Ten-year Treasury yields jumped as much as 25 basis points (or 0.25%) in recent weeks, despite favorable inflation figures. The yield curve steepened, with long-term rates rising faster than short-term rates, which is known as a "bear steepener" since prices moved lower. It was a short-lived episode but illustrates the risks to the market from fiscal policy concerns.

We have been looking for a steeper yield curve, but our expectation was for a "bull steepener" where yields for short-term bonds fall faster than yields for long-term bonds. That is still our expectation for the second half of the year. We look for the Fed to cut short-term rates starting in the fall of 2024 and continue lowering them in 2025. Since the yield curve is already inverted, there is less room for long-term rates to drop than short-term rates.

Meanwhile, markets continue to price in the probability of Federal Reserve rate cuts later this year and into 2025 in response to easing inflation pressures and slowing growth. Recent data suggest the economy's growth rate is slowing down as consumer spending cools off, while inflation is edging lower. As a result, yields have fallen after the spike up in June.

Lower interest rates could help ease some of the pressure on the budget deficit because financing costs are a major contributor to the growth in government debt. However, the Fed may not feel as confident about inflation trending lower if fiscal policy is expansive going forward. As a result, the positive impact may be limited.

The U.S. dollar is likely to be caught in this tug-of-war as well. Typically, when the Fed is easing policy in response to softer growth and inflation, and a weakening labor market, we would expect the dollar to decline, especially after rising for more than a decade. However, the prospect of expansive fiscal policy and potentially tighter monetary policy could keep it higher for longer.

We continue to expect the growth and inflation numbers to outweigh budget concerns in the long run, but the clash of these two forces is likely to mean higher volatility in the second half of the year. Although volatility has increased in recent weeks, it is still relatively low by historical standards. Investors should prepare for it to rise and potentially stay higher in the months ahead.

The closer the polls, the more risk, and the more nervous the bond market is likely to be, as politicians on both sides of the aisle could propose policies that would expand the deficit in order to please voters. Nonetheless, we are focusing on the long-run prospects for lower inflation and suggest using bouts of volatility to add to positions in high-credit-quality bonds, such as Treasuries and investment-grade corporate and municipal bonds. Real interest rates—those adjusted for inflation—are at the highest levels in more than 15 years, providing some compensation for longer-term risks. U.S. yields are also significantly higher than those in other developed-market countries, which should keep the dollar firm and support capital inflows.

Higher volatility can be unsettling, but it also can present opportunities for investors. Given our expectation that interest rates will head lower in the second half of the year, we continue to suggest extending duration to mitigate reinvestment risk—the risk that investors will be forced to reinvest proceeds from maturing securities at lower rates. We also suggest investors focus on higher-credit-quality securities, such as Treasuries or investment-grade corporate bonds. We believe a diversified portfolio of fixed income investments with higher credit quality can help investors capture attractive yields with the potential for positive total returns.  

To keep up on developments in Washington, D.C. you can read commentary from our own Michael Townsend on schwab.com and/or listen to his WashingtonWise podcast.