Fed Cuts Rates, Yields Soar: The Surprising Market Reaction Explained

On September 18, 2024, the Federal Reserve delivered an unexpected surprise by cutting interest rates by 50 basis points. Just days earlier, the market had widely priced in a smaller 25-basis-point cut. One day before the meeting, the market was pricing in a 50-50 chance of a 50bp cut. Naturally, you’d expect such a sharp policy easing to send bond yields tumbling, but instead, the opposite happened.

On the day of the announcement, the U.S. 2-year government bond yield closed at 3.62%. Fast forward to today, at the time of writing this, it has climbed to an impressive 4.31%, marking an almost 70-basis-point increase. At one point, the yield had risen by more than 75 basis points before retracting slightly. This dramatic surge wasn’t confined to shorter-term yields. Long-term rates also saw significant moves, with 10-year and 30-year yields rising by 76 and 64 basis points, respectively. So, what’s driving this move, where a big surprise rate cut—typically a catalyst for lower yields—has instead resulted in a sharp climb?

A key factor lies in the strength of recent U.S. economic data, which has consistently exceeded expectations since the Fed’s rate cut. This has prompted questions about whether such an aggressive policy shift was necessary in the first place. Analysts argue that initiating a steep rate-cut cycle when the economy appears robust could risk overheating, potentially reigniting inflation. Some even view the Fed’s 50-basis-point cut as a “policy error,” suggesting it was unwarranted given the current economic momentum. While everything looks easy to predict in hindsight, the uncertainty surrounding the Fed’s future moves has led markets to adjust expectations, effectively pricing out additional rate cuts. This shift in sentiment has directly contributed to the rise in yields. Image below is of the US Citi Surprise Index, which shows how actual realized economic data has been coming in with respect to the expectations. We can clearly see that US economic data has been consistently coming in stronger than expectations since a while now.

Adding to this dynamic is the recent U.S. presidential election, which saw Donald Trump winning the election. Set to take office in January 2025, Trump’s return has heightened market expectations of inflationary pressures. His policies, particularly trade tariffs and unfunded tax cuts, are widely viewed as more inflationary compared to those of his opponent, Kamala Harris. Higher inflation prospects translate into expectations of fewer rate cuts and ultimately higher rates. Moreover, Trump’s fiscal agenda is anticipated to widen deficits, leading to increased bond issuance. This additional supply of government bonds would likely push yields higher, as investors demand a greater risk premium.

The impact of rising yields has also been felt in currency markets. Due to the rising US yields, the Dollar has strengthened significantly with respect to other major currencies. The image below shows the Dollar Index, a nice representation of the dollar strength/weakness against other currencies. As you can see, we have seen a sharp strengthening since the past few weeks.