How changing interest rates impact the bond market

Interest rates, along with changing credit quality and supply dynamics form basic bond market fundamentals. Bond investors evaluate shifting interest rates for opportunities and risks in their bond investments. Many investors consider bonds outside the U.S. Treasury market to diversify their portfolios, especially when interest rates approach key levels. Recently, 10-year Treasury yields dropped near 4.00%, marking the lower end of their year-to-date range.¹

“Recently falling Treasury yields reflect investor expectations the Federal Reserve (Fed) will cut policy rates more than they’d previously anticipated as the Fed attempts to balance softer labor market conditions against persistent inflation,” notes Bill Merz, head of capital markets research with U.S. Bank Asset Management Group. “Declining bond yields can reflect weaker economic growth or inflation expectations.” However, recent stock market strength suggests investors believe the Fed’s recent interest rate cuts are responding to past soft data, such as downward revised job gains, not future growth concerns. The Fed has updated its growth projections and economists’ consensus growth estimates have improved recently, while analysts have upgraded corporate earnings growth forecasts.

“Economists predicted modestly higher inflation this year, and recent data confirmed those forecasts. Consensus now points to a gradual slowdown in inflation,” says Merz. “Tariff price pressures appeared in business surveys and accelerating core goods prices, but these effects haven’t been extreme.” Year-over-year inflation, as measured by CPI, decelerated from 3.0% in January to 2.7% in June before rising back to 3.0% in September.²

Watching the Fed and Congress

Investors closely monitor Fed policy decisions. At its October meeting, the Federal Open Market Committee (FOMC) cut the federal funds target rate by 0.25% to a range of 3.75% to 4.00%, following three cuts in late 2024. Markets and median Fed member projections anticipate another rate cut in December and up to three more in 2026.³

Congressional actions also influence fixed income markets. Early in 2025, the federal government reached its debt ceiling, limiting new Treasury Department issuance beyond replacing maturing bonds. The Treasury spent down much of its cash balance, which normally hovers around $850 billion. With the debt ceiling lifted, the Treasury replenished cash balances and now must issue new Treasury debt to fund budget deficits and replace maturing debt. “Muted Treasury supply earlier this year has ended, but Treasury Secretary Scott Bessent plans no increase in auction sizes for longer maturities,” says Merz. “Rather, the Treasury indicates it will issue more short-term bills where heavy issuance is unlikely to disrupt broad bond market pricing in the near term.”

The “One Big Beautiful Bill Act” extends current tax rates and adds some new tax cuts, while only modestly trimming spending. The Congressional Budget Office projects that the legislation will result in a $3.4 trillion increase to federal debt by 2034 .⁴ This eventual increase in borrowing could add to U.S. Treasury issuance through time, pushing interest rates higher.

 “Recently, rate cut expectations pulled Treasury yields lower. Bond buyers would like to see spending cuts or increased taxes to bring Treasury supply lower. But recently, Fed rate cut expectations overcame debt issuance concerns.”

The Trump administration continues to pursue deregulatory changes, affecting sectors such as energy, mining, cryptocurrency, and artificial intelligence. President Trump has curbed independent agencies’ powers to implement new regulations without executive oversight, while the Federal Reserve, working with other regulators, may soften rules that limit banks’ Treasury ownership. Tariff revenues could offset new legislation costs, also impacting Treasury supply and demand.

A changing yield curve

The yield curve, which compares Treasury yields across maturity dates, has shifted. Normally, longer-term bonds offer higher yields than shorter-term bonds to compensate investors for committing their money for extended periods. However, Fed interest rate policy, which influences shorter maturities more than longer maturities, can cause yield curve changes. The yield curve had been flatter than normal and was inverted, meaning short term yields were higher than long term yields, from mid-2022 to later in 2024 as the Fed’s policy rates were restrictively high and investors expected them to lower short-term rates in time. Currently, the 10-year Treasury yields 0.50% more than the 2-year Treasury; that difference is commonly referred to as a “spread” between one yield and another.¹ By comparison, since 1977, 10-year Treasuries have historically averaged near a 0.80% yield spread over 2-year Treasuries.

Finding opportunities in today’s bond market

How should investors approach fixed income markets today? Investors may wish to emphasize inflation sensitive assets across their portfolios while incorporating more complex credit to enhance income and manage tariff-related inflation risk.  Beyond bonds, we also recommend global infrastructure and global equities to capitalize on continued economic expansion. “Economic conditions can support continued earnings growth, creating favorable equity and real asset return opportunities,” says Haworth.

Talk to your wealth professional for more information about how to position your fixed income investments consistent with your goals, investment time horizon, risk tolerance and tax profile.

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.

The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is generally free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes.