Fed’s Hawkish Talons Shine, Bond Market Believes: US Treasury Yield Curve Flattens as Rate Hike Bets Heat Up

According to Zhitong Finance APP, the bond market is sending out increasingly strong signals of confidence that Federal Reserve Chair Kevin Walsh will fulfill his commitment to curb inflation—which has now exceeded policymakers’ target for five consecutive years.

After the Federal Reserve raised borrowing costs for the first time since 2023 on Wednesday and signaled further tightening ahead, traders now expect three more rate hikes by the middle of next year, one more than was anticipated prior to the announcement. Rate swaps indicate that the first hike could come as early as next month.

This repricing pushed the two-year U.S. Treasury yield to its highest level since 2024, reflecting the market’s view that the Fed is willing to implement meaningful tightening policies to slow the economy and suppress inflation. This potentially presents a headwind for the U.S. stock market, which has already responded with declines.

Although Walsh was careful not to pre-commit to any future moves, his emphasis on dissatisfaction with the inflation trajectory clearly communicated the Fed’s policy intent. This stands in stark contrast to the market’s reaction to the Fed’s decision to hold rates steady in July—when Walsh’s vague comments about plans to lower price pressures triggered a selloff in long-term bonds.

“We are shifting from concerns about the Fed’s credibility to focusing on the economic impact of the Fed’s commitment to bring inflation back to target,” said Priya Misra, portfolio manager at JPMorgan Asset Management.

The two-year U.S. Treasury yield—the maturity most sensitive to Fed expectations—rose from 4.6% before the Fed statement to 4.74%. The increases in longer-term Treasuries, which are more sensitive to inflation, lagged behind—indicating investors expect officials to act to control price pressures. Meanwhile, long-term inflation expectations dropped sharply.

At the post-meeting press conference, Walsh reiterated concerns about inflation, saying recent data “does not tell me there has been substantial improvement in the underlying trend.” In another statement, the Fed said the rate hike “will support a more timely return to the Committee’s 2% goal”—referring to the inflation target.

“This was a credibility test meeting for Walsh,” said Jeffrey Rosenberg, senior portfolio manager at BlackRock, “and the market is now seeing him as a much more credible Fed chair.”

With inflation exceeding the Fed’s 2% target for over five years, traders had already priced in over a 90% probability of Wednesday’s rate hike. According to compiled data dating back to 2008, every time rate hike expectations have been this high, the Fed has always delivered.

These expectations began to heat up last month when Walsh said the Fed would ensure inflation “cools at a sufficiently fast pace.” The outlook was largely cemented after data last week showed August core inflation rising more than expected. Meanwhile, U.S. job growth surged and the unemployment rate remained stable, offering evidence of robust momentum in the labor market.

“The Fed is essentially telling the market: With a stronger economy, a tighter labor market, and more persistent inflation, policy needs to remain tighter for longer to restore price stability,” said Daniel Siluk, portfolio manager at Janus Henderson Investors.

The divergence between short-term and long-term U.S. Treasuries has flattened the yield curve, with the gap between two-year and 30-year yields narrowing to its tightest closing level since March 2025. This further confirms the trend of repeated shocks to the bond market from Fed decisions and Walsh’s remarks.

Since Walsh took charge of the Fed in May, the biggest single-day moves in this yield curve indicator have occurred after his appearances: following his first two post-meeting press conferences in June and July, and after his speech at the Fed’s annual conference in Wyoming in August.

Admittedly, although the Fed somewhat eased concerns on Wednesday regarding its commitment to fighting inflation, it will still need to act if price pressures remain high. Currently, market expectations for rate hikes next year even exceed the forecasts of the Fed’s most hawkish officials.

Prior to Wednesday’s decision, the 10-year and 30-year U.S. Treasury yields jumped to their highest levels since 2007. This round of rising yields is part of a global increase since the U.S. and Israel launched strikes against Iran in February—an event that disrupted Middle Eastern energy supplies and sent oil prices soaring.

Other forces are also driving yields higher, such as large-scale borrowing by corporates to fund artificial intelligence (AI) spending, bringing a wave of debt to the market and further stimulating the already resilient U.S. economy.

“Amid supply and demand shocks, destroying demand via higher rates is the only way to fight inflation,” said Luigi Buttiglione, CEO of consultancy LB Macro, “It’s hard to see how bonds and stocks can withstand this headwind.”