Traders Ramp Up 'Soft Landing' Bets as Treasury Yields Rise

Yields on long-term U.S. Treasury bonds rose on Monday as investors placed bets on the Federal Reserve successfully achieving a "soft landing" for the economy—a scenario in which the Fed reduces inflation without triggering a recession.

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According to data, the yield on the 2-year Treasury note increased by 3 basis points, reaching 3.5616%. Meanwhile, the yield on the 10-year Treasury note rose by 5 basis points to 3.782%, and the 30-year Treasury bond saw a 4-basis-point increase, climbing to 4.121%. Treasury yields move inversely to bond prices, meaning yields rise when bond prices fall.

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Last week, the yield curve—the difference between short-term and long-term Treasury yields—widened after the Federal Reserve made a larger-than-expected cut to its target interest rate, lowering it by 50 basis points. This was more aggressive than many Wall Street analysts had anticipated.

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Since then, yields on longer-term bonds have risen faster than those on short-term bonds. This trend represents a reversal of a popular "recession trade," where investors had expected the Fed’s interest rate hikes to slow down economic growth and trigger a recession. The soft-landing scenario now seems more plausible, as indicated by commentary from Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, shared with MarketWatch early Monday. According to Shalett, this shift in sentiment reflects increased confidence that the Federal Reserve, led by Chair Jerome Powell, can manage inflation without causing a severe economic downturn.

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Powell reaffirmed this optimism in a press conference last week, stating that the decision to implement a larger interest rate cut was not a signal of economic weakness. Instead, it was a strategic move to ensure that the labor market remains resilient. The Fed’s forecasts hinted at two more 25-basis-point rate cuts later in the year. However, traders have now started speculating that one of the remaining meetings could bring another 50-basis-point cut, which has further bolstered expectations for a soft landing.

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As a result, the yield curve steepened further into positive territory on Monday, reflecting increased optimism in the bond market. Analysts from FHN Financial noted that the yield curve had not been this steep since June 2022.

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For over two years, short-term yields had been higher than long-term yields, a phenomenon known as an inverted yield curve. Typically, an inverted yield curve signals market expectations of an economic slowdown. However, this inversion ended earlier in the month as the Federal Reserve prepared for its first interest rate cut in the current cycle.

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As of Monday morning, long-dated yields remained at their highest levels in two weeks, with investors continuing to digest comments from Federal Reserve officials. Larry Milstein, managing director of government and agency trading at R.W. Pressprich & Co., explained during an interview with MarketWatch that there is growing anticipation of more interest rate cuts, which is contributing to the steepening of the yield curve, particularly at the short end.

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Monday’s market session was relatively quiet due to a holiday in Japan, but U.S. traders were closely watching fresh data on manufacturing and service-sector activity. The data showed that the services sector continued to expand, while manufacturing struggled. This caused Treasury yields to edge even higher throughout the day.

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Looking ahead, more significant economic data is expected later in the week, which could have a stronger impact on the markets. Investors are waiting for the latest report on second-quarter GDP growth, as well as the Personal Consumption Expenditures (PCE) price index, which is the Federal Reserve’s preferred measure of inflation. These reports will provide further clues about the health of the economy and the Fed’s potential next moves.

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In addition to economic data, the bond market will also need to absorb a substantial influx of new supply. The U.S. Treasury is scheduled to auction $69 billion worth of two-year notes on Tuesday, followed by $70 billion in five-year notes and $4 billion in seven-year paper on Wednesday and Thursday, respectively. This increased supply could put further pressure on bond prices, pushing yields higher.

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The rise in long-term Treasury yields is seen by many as a positive signal for the economy, as it suggests that investors are less worried about an imminent recession. The Fed’s aggressive rate cuts have calmed fears of a deeper economic downturn and have encouraged optimism that inflation can be tamed without significant job losses or a contraction in economic activity.

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However, there are still risks to this outlook. While the bond market has shifted its focus to a soft landing, future data could complicate this narrative. If inflation does not cool off as expected or if economic growth falters, the Fed might have to adjust its policy, potentially bringing volatility back to the markets.

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The Treasury auctions later this week will also serve as a key test for investor demand, as large issuances of government debt can put pressure on the market. If the demand for these bonds falls short of expectations, yields could climb even further.

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In conclusion, long-term Treasury yields are rising as investors gain confidence in the Federal Reserve’s ability to navigate the economy toward a soft landing. While this optimism is driving the market now, upcoming economic data and bond market developments will play a crucial role in determining whether these hopes are realized or if challenges lie ahead.

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