The complex relationship between interest rates, the Federal Reserve's monetary policy, and mortgage rates has left many American homebuyers feeling frustrated and perplexed. As the central bank embarked on a series of interest rate cuts, it was widely anticipated that mortgage rates would decline, thereby facilitating home purchases. However, contrary to expectations, mortgage rates have significantly risen in the aftermath of these cuts, particularly following the Federal Reserve's third consecutive reduction in September.

According to data from Freddie Mac, the average interest rate on a 30-year fixed mortgage in the United States rose from approximately 6.1% to around 6.7% in the months following the Federal Reserve's actions. This unanticipated hike in mortgage rates is intrinsically linked to the yields on 10-year U.S. Treasury bonds, which have surged dramatically in recent months. The ripple effects of this shift have rippled through the housing market, making affordability an escalating concern for potential buyers.

This cycle of monetary easing could be described as one of the most challenging periods for bond traders in decades. Typically, periods of easing by the Federal Reserve would lead to gains in bond markets as lower interest rates would boost cash flow from existing bonds. However, the loss experienced by bond traders in this current cycle is alarmingly profound, raising fears that similar patterns will continue into 2025.

Astonishingly, since the onset of the Federal Reserve’s interest rate cuts in September, yields on 10-year Treasury bonds have increased by more than 75 basis points. This surge in yields seems counterintuitive, as one would generally expect that rate cuts would encourage falling yields. Instead, we are witnessing the largest three-month increase in yields at the inception of a rate-cutting cycle since 1989.

The increased yields on long-term bonds are primarily fueled by rising expectations regarding future short-term interest rates rather than current levels. Despite the Federal Reserve's consistent decrease in benchmark rates, perceptions about the trajectory of future rates have taken an upward turn in response to broader economic indicators.

Even following the Federal Reserve’s latest meeting, where rates were cut for the third time, 10-year Treasury yields surged to their highest levels in seven months. Federal Reserve officials, including Chair Jerome Powell, communicated a readiness to significantly slow the pace of monetary easing in the upcoming year, contributing to this climb in yields. Sean Simko, global head of fixed income portfolio management at SEI Investments, commented that "U.S. Treasury yields are being repriced to reflect expectations for higher long-term returns and a hawkish Fed narrative."

In many respects, the rise in yields showcases the distinction of this particular economic and monetary cycle. Despite the increasing cost of borrowing, the resilience of the U.S. economy continues to push inflation rates above the Federal Reserve's 2% target, prompting traders to abandon bets on aggressive cuts in the year ahead and extinguishing hopes for a comprehensive rebound in bond prices.

This tumultuous year for bond traders threatens to culminate in disappointment, as the entire national debt market is barely managing to stay level with the start of the year. The Bloomberg U.S. Treasury Bond Index has fallen for two consecutive weeks, nearly erasing all gains from earlier in the year, with long-dated bonds leading the decline. Since the Federal Reserve's rate cuts began in September, this index has dropped by approximately 3.6%.

Historically, during the first three months of the last six easing cycles, bond markets experienced positive returns. However, the current environment represents an anomaly, raising questions about the future trajectory of both the economy and interest rates.

Looking ahead, the prospects for the coming year appear daunting. Bond investors must navigate not only the possibility of the Federal Reserve remaining inactive for an extended period but also the potential turbulence stemming from an incoming administration. Jack McIntyre of Brandywine Global Investment Management underscored this uncertainty by stating, “The Fed has entered a new phase of monetary policy—the pause phase. The longer this persists, the more likely the markets are to price in both rate increases and decreases equally.”

In a surprising twist from last week's end-of-year meeting, the Federal Reserve's dot plot has significantly reduced the expected number of interest rate cuts for the following year to two, a clear reflection of the shifting landscape. Furthermore, an unsettling revelation emerged: out of 19 Federal Reserve officials, as many as 15 expressed concern regarding the risks of rising inflation, a sharp increase from just three during the September meeting.

In response to this shift in sentiment, interest rate market traders rapidly recalibrated their expectations. Recent swap market data indicates that traders are not adequately pricing in further rate cuts in the first half of next year as they currently bet on approximately 37 basis points of reductions, a figure that remains substantially lower than the Federal Reserve's dot plot forecast of 50 basis points.

The recent downturn in long-dated bonds has not attracted the usual influx of bargain-hunters that one might expect in such circumstances. A team of strategists at JPMorgan, led by Jay Barry, recently suggested clients consider buying two-year bonds. Still, they noted little inclination to purchase longer-term securities, citing “a lack of key economic data in the coming weeks, reduced trading volume as the year closes out, and an influx of new long-dated supply”—as the U.S. Treasury plans to auction approximately $183 billion in bonds shortly.

In this challenging landscape, one strategy appears to be holding its ground—betting on the steepening of the yield curve, which posits that short-term Treasuries sensitive to Federal Reserve actions will outperform their long-term counterparts. This environment creates optimal conditions for a steepening curve strategy, as the yield on the 10-year Treasury surged to more than 25 basis points above that of the two-year Treasury, marking the widest gap since 2022.

Even as economic indicators evolve, the underlying logic of this strategy remains clear. Investors see value in the short end of the curve, with two-year note yields nearing 4.3%, almost equivalent to that of three-month T-bills (functionally cash). Should the Federal Reserve’s rate cuts exceed expectations, two-year bonds could present a significant upside in terms of price appreciation.

From a cross-asset perspective, given the lofty valuations of U.S. equities, two-year Treasuries may represent compelling value in the current climate. Michael de Pass, global rates trading head at Citadel Securities, asserts, “The market may consider bonds quite cheap—certainly in comparison to equities—and view them as insurance against potential economic slowdown risks. The question remains how much to pay for that insurance. In today's context, you're not required to pay much at all.”

In contrast, long-term Treasuries may struggle to attract buyers in an environment plagued by persistent inflation and a still-robust economy. Some investors are remaining cautious regarding policy agendas that could not only spur economic growth and inflation but also exacerbate an already burgeoning budget deficit. Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, argues that factors relating to government expenditure will undoubtedly drive long-term bond yields higher. He has recently leaned towards inflation-linked bonds as a “reasonably cheap hedge” against CPI increases.