Jerome Powell has breathed fresh life into one of bond traders’ time-honoured strategies. The much-anticipated Fed rate cut on Wednesday didn’t cause much of a stir in Treasury yields, which ended the week largely unchanged. However, Powell’s half-point cut has quietly widened a crucial gap in the bond market that could have significant implications.

Here’s the well-known mechanism: Short-term yields naturally drop when the Fed starts trimming its overnight benchmark rate, but long-term yields don’t follow as quickly. The reason? Lingering inflation risks that hang over the long-term economic outlook. The result is a steeper yield curve, with short-term rates dipping further below longer-dated bonds.
This steepening was evident last week. While two-year Treasury yields slipped slightly, 10-year yields rose, widening their gap to its most significant point since 2022.

For the past two years, traders have been waiting for this steepening, only to be caught off guard as the Fed kept raising rates to two-decade highs and held them there. But with the Fed now shifting course to support the economy, the yield curve is finally beginning to steepen. The gap between 2 and 10-year yields has widened for five straight weeks—the longest stretch since October 2021.

With Fed officials targeting a reduction in the benchmark rate from 4.8% to around 3.4% by the end of 2025, investors are growing more confident that the trend will continue. The curve steepened further last Friday after Fed Governor Christopher Waller hinted at another potential 50-basis-point cut if the labour market weakens.

Of course, nothing in the market is ever certain. The resilience of the post-pandemic economy has repeatedly surprised both economists and investors. Still, the yield curve remains flatter than in previous easing cycles, suggesting that there’s room for more steepening. Current market projections indicate that the spread between 2 and 10-year yields could widen to about 55 basis points over the next 12 months, up from around 15, anticipating a recession.
A steepening curve can also be beneficial in a downturn, as the Fed tends to act aggressively to fend off economic weakness.

So, while those who have patiently waited for the Fed to pivot may feel reassured, the question remains: Will the yield curve continue its steepening path, or could it flatten once again, caught in the unpredictability of global economic forces?