Don’t fight the Fed – it’s the main driver of US bond yields

An unexpected rally

The most recent market surprise wasn't geopolitical tensions or an earnings miss, it was the unexpected fall in long-term bond yields. US 10-year Treasury yields declined by approximately 20 bps in the first part of  September 2025 alone, flirting with the 4% threshold and providing broad support to risky assets. European rates followed a similar trajectory. 

The rally presents a paradox. Throughout 2024, two primary factors drove long-end yield volatility: inflation (potentially exacerbated by tariff policies) and mounting fiscal risks (as debt concerns demanded urgent attention across the major economies). Inflation and fiscal risks are still in play, yet yields continue to retreat despite these persistent structural headwinds. 

Monetary policy expectations are driving the counterintuitive move, with markets now pricing in two to three rate cuts in the coming months. This raises critical questions for investors: can the Federal Reserve (Fed) truly drive the entire term structure lower in the challenging macro context? And can central bank policy at the short end of the curve overcome legitimate inflation and fiscal concerns at the long end?

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One factor explains yield moves

Classic fixed income research has found that a single "level" factor explains between 80-95% of yield curve moves. While factor analysis excels at identifying key drivers and their relative importance, it often struggles to assign intuitive labels to these factors. 

However, since Vasicek's groundbreaking model and its subsequent iterations, the picture has become clearer: the dominant factor is monetary policy. The dynamics around the short rate make lasting impacts on market expectations, giving central banks the power to drive the entire term structure up and down. 

The evidence from principal component analysis is compelling. Changes in Fed policy rates account for 43% of one-month variations in the first principal component of the US yield curve. Even more remarkably, Fed rate changes correlate with 32% of moves in the first factor driving 10-year yields across the US, Germany, Japan, and the UK from 1964-2025, based on Stambaugh's methodology of analysing investments with differing historical lengths. 

As Figure 1 illustrates, the first principal component moving either US or global yields is largely explained by Fed rates – it’s truly the tide that lifts all boats, or rather in this case, sinks global rates. Perhaps what we witness currently is precisely this phenomenon in action.

FIG 1. Fed rates vs cumulated evolution of the first factor of the US yield curve¹

 
 

A changing correlation

Still, this reasoning is not always correct because the explanatory power of Fed rates varies significantly over time. As surprising as it may seem, Fed rates don't show a constant correlation over long periods, as illustrated in Figure 2. The chart shows the evolution of the 10-year trailing correlation between upcoming changes in Fed rates and the first principal components of both US and global yield factors. This correlation can reach impressive heights during certain periods – such as the early 1960s or the 1980s – and is typically stronger for US yields than for global ones. 

But it fluctuates meaningfully, too. From the late 1990s to the mid-2000s, former Fed chairman Alan Greenspan expressed concerns about why the long end of the curve was no longer responding meaningfully to central bank adjustments in what became known as the Greenspan conundrum. The lack of curve response to policy rates was caused by several factors: 

• The global savings glut, particularly from Asian economies recycling trade surpluses 
• Enhanced central bank credibility in fighting inflation and
• Increased demand for long-duration assets from pension funds and insurance companies. 

Figure 2 captures this dynamic, showing declining correlation in 1990-2000. The weakened transmission mechanism ultimately prompted former Fed chairman Ben Bernanke to implement quantitative easing as a way to combat a loosening correlation trend. The Fed needed new tools when traditional policy failed to filter effectively through the yield curve. 

FIG 2. 10-year rolling correlation between next 6-month Fed rates and the first factor of US and world yield curves²

 
Today, the notable change is that the correlation has largely normalised in recent years. The Greenspan conundrum no longer applies. This normalisation places the Fed in a stronger position to influence the entire yield curve and explains much of the current market behaviour.

How much do rate cuts move yields and why does pace matter?

Currently, markets price in two more Fed cuts by year-end, primarily due to unemployment concerns. The expectation of accommodative policy makes perfect sense given the intensity of negative job creation revisions, the overall decline in leading indicators and deteriorating consumer survey data. Growth has clearly surpassed inflation as the primary concern for US policymakers, opening the way for a series of reductions – and not as a result of politically complacent adjustments. The lower rate path represents a meaningful shift in the Fed's reaction function and market expectations. 

How will the transmission of Fed cuts be priced into the broader yield curve? Figure 3 quantifies this relationship precisely: with three cuts expected in the next six months, yields typically decline by a modest 3-5 bps – hardly moving the needle for long-duration assets. However, six cuts in six months alter the scenario significantly. The faster pace would signal emergency conditions that would typically drive 10-year yields lower globally by approximately 20 bps. 

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This faster rally is precisely what occurred in September. To see this magnitude of moves repeat, two critical conditions are necessary: the anticipated cuts must materialise and the Fed must provide explicit forward guidance about the continuation of this series of cuts. Without these elements, the 4% threshold for 10-year yields could suddenly feel much more solid than currently. 

For now, Fed expectations are in the driving seat for long yields. Yet for that dynamic to last, the Fed must be explicit about what comes next – its communication following the September FOMC meeting helped in this respect.

FIG 3. 10-year yield change as a function of the number of upcoming rate cuts in the next six months³

 

The implications for multi-asset investors

Fixed income is one component of the protection assets we use in our multi-asset strategy. To enhance diversification, we combine bonds, commodities and volatility strategies (diversifiers) with credit and equity exposures (common cyclical exposures). The diversification potential of bonds appears particularly valuable again, in our view, given the dovish rates context discussed in this article. Stubbornly rising equity markets could face headwinds from the soft US job market, and, again, signal to us that diversification could gain value again in cross-asset solutions.

Simply put, the Fed still rules the yield curve – but only as long as markets believe the central bank’s commitment to cutting rates.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Signals for our growth nowcaster remained unchanged with a slight uptick in China and the eurozone, the nowcaster is in a low but rising zone
• Our inflation indicator increased in the US, but this was offset by a decrease in China
• The monetary policy indicator declined, especially in the US, mainly due to a decrease in capacity utilisation data.
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
 
World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).