Treasury yields stayed elevated even as peace deal optimism eased oil fears, with sticky core inflation, resilient growth and rising term premium keeping the bond market's hawkish bias firmly intact.
The benchmark U.S. 10-year Treasury yield retreated on Monday as investors welcomed the preliminary peace agreement between the U.S. and Iran, which is scheduled to be formally signed on Friday. The prospect of the Strait of Hormuz reopening sent oil prices sharply lower, easing concerns that a prolonged energy supply disruption would fuel a fresh bout of inflation. As a result, investors moved back into government bonds, pushing yields lower.
Yields Ease, but Hawkish Signals Persist
Yet the decline in yields was relatively modest compared to the sharp rise seen during the conflict. Even after Monday's pullback, the 10-year yield remains well above the levels prevailing before the outbreak of hostilities in late February, suggesting that the bond market is not ready to declare victory over inflation just yet.
Treasury Sheds Some of Geopolitical Premium
Source: TradingView
The resilience in yields indicates that investors continue to see risks extending beyond the immediate geopolitical crisis. Stronger-than-expected economic data, sticky core inflation and growing expectations that the Federal Reserve may need to keep interest rates higher for longer have all contributed to the upward pressure on Treasury yields in recent weeks.
The 2-year Treasury yield, which is highly sensitive to expectations for Fed policy, remains elevated despite Monday's decline, suggesting traders continue to see a meaningful risk of further policy tightening. At the same time, the 10-year yield has held onto much of its recent gains, indicating that concerns about inflation and growth remain embedded in longer-term market expectations.
2-Year Vs. 10-Year T-note Yield
Source: TradingView
Lloyd Financial Chief Investment Officer Colin Symons opines that both sides are contributing to the yield spike, with the shorter-end being driven by inflation worries and the longer-end by the “run-it-hot” policy. The strategist, however, says the resilient growth is partly due to inventory build as companies anticipate oil-driven business interruption.
Symons cited the San Francisco Fed model, which says most of the growth, particularly on the longer end, is due to a higher term premium. In other words, the increase is not because investors expect the Fed to raise rates, but because they require additional compensation for bearing long-term risks.
The message from the bond market is clear: lower oil prices alone may not be enough to justify a more dovish outlook.
That is precisely why the upcoming Federal Reserve meeting has assumed greater significance. With the geopolitical shock fading, investors will be looking to policymakers for clues on whether they share the bond market's view that inflation risks remain elevated enough to keep another rate hike in play later this year.
Why the Bond Market Has Turned Hawkish
The bond market’s hawkish leaning could be the bye-product of three key developments: sticky core inflation, resilient growth and geopolitical tensions that have engendered supply shocks.
The May inflation report offered a mixed picture. Headline consumer prices rose faster than expected on both a monthly and annual basis, driven primarily by higher energy costs. While the core measure, which excludes volatile food and energy prices, came in below consensus estimates, core inflation remained elevated at 2.9% year-over-year, well above the Fed's 2% target.
At the same time, the broader economy has continued to display remarkable resilience despite months of geopolitical turmoil. The Atlanta Fed's GDPNow model currently estimates second-quarter growth at 3.3%, a pace that would comfortably qualify as above-trend growth for a mature economy such as the United States. The labor market has also remained firm, with employers adding a robust 172,000 jobsin May.
To be sure, not all the economic data have been encouraging. Industrial production was subdued in May, while a regional manufacturing survey pointed to a notable slowdown in activity in the New York area. Even so, the overall picture remains one of an economy that continues to expand at a healthy pace rather than one in need of immediate monetary support.
That said, Lloyd Financial’s Symons said the bond market is overreacting, especially as the odds of a rate hike in the immediate near term are very low. “That said, an oil shock like that is always going to cause worry, and markets generally overreact, then walk it back. Very normal behavior,” he added.
The Real Story Isn't the Rate Decision — It's What the Fed Says Next
The next Federal Open Market Committee (FOMC) meeting is scheduled for Tuesday and Wednesday.
Few expect the Fed to raise interest rates at this week's meeting, making the policy statement, updated economic projections and the dot plot far more important than the rate decision itself. Investors will be looking for signs of whether policymakers share the bond market's increasingly hawkish assessment of the economy.
Upward revisions to inflation or growth forecasts, fewer projected rate cuts, or indications that some officials still see the need for additional tightening would validate the recent rise in Treasury yields. Conversely, the Fed may emphasize moderating core inflation, pockets of economic weakness and the recent easing in energy prices to justify a patient approach.
Ultimately, the key question for markets is whether policymakers view the recent increase in yields as an overreaction to geopolitical and inflation concerns or as a justified repricing of a higher-for-longer interest-rate environment.
When asked whether the bond market can tighten financial conditions with a Fed hike, Symons said it is possible through credit spreads and higher discount rates. The strategist also expects the yield spreads to steepen, taking longer rates higher. While this has happened in the past, signs of it happening now isn’t evident, he added.
Is the Fed Actually Ready to Follow?
The evidence suggests the Fed is edging toward the bond market's view but cautiously and on its own timeline.
Three signals point in that direction:
- Fed's own rhetoric has shifted. Officials have largely stopped talking about rate cuts as an imminent prospect, with several recent speeches emphasizing patience and data dependence over any rush to ease.
- The updated Summary of Economic Projections due Wednesday is widely expected to show upward revisions to inflation forecasts and a reduction in the number of projected rate cuts for 2026, a tacit acknowledgment that the bond market's hawkish repricing has merit.
- The very fact that markets are pricing a 56% probability of at least one rate hike by year-end suggests the Fed has done little to push back against that expectation.
Yet there are reasons the Fed may stop short of fully validating the bond market's stance. The Fed is likely to adopt a mildly hawkish tone, acknowledging the rise in bond yields and tighter financial conditions, but stopping short of signaling that rates need to rise as much as the bond market currently implies.
In short, the Fed is ready to follow but just not at the bond market's pace.