US two-year yields ease as inflation expectations drop below Fed target
A drop in short-term US Treasury yields reflects growing market confidence that the Federal Reserve will hold rates steady, as inflation expectations fall below the central bank's target despite elevated oil prices.
Shorter-dated US Treasury yields fell on Tuesday as a dip in oil prices helped push market-based inflation expectations below the Federal Reserve’s 2% target for the first time since October 2024. The yield on the 2-year note, which closely tracks Fed policy expectations, dropped 1.7 basis points to 4.198%, snapping a three-session winning streak. Meanwhile, the benchmark 10-year yield was largely unchanged at 4.598%.
The move lower in short-term yields was driven by cautious optimism over Middle East diplomacy, which briefly offset lingering geopolitical risks. A proposed 10-day ceasefire for Tehran helped moderate oil prices. However, the Iran-aligned Houthis' decision to impose a naval blockade on Saudi Arabia on Monday kept Brent crude just below $90 a barrel, a five-week high.
For fixed-income investors, the critical takeaway is the continued disconnect between elevated energy costs and broader US inflation expectations. A market-based measure of one-year-ahead inflation slipped beneath the central bank's target, building on a softer-than-anticipated June consumer price index reading. This combination has effectively neutralized the threat of a near-term interest rate hike.
Money markets are now anticipating that the Federal Reserve will keep rates unchanged at its upcoming policy meeting next week. Policymakers are currently in a blackout period ahead of that gathering, and a sparse US economic calendar this week leaves the bond market highly sensitive to shifting inflation narratives.
"Despite the recent rally in oil prices, market-based measures of inflation have stayed well anchored," strategists at ANZ Research said in a note. They attributed this stability to the central bank's established credibility in inflation management, fading impacts from tariffs, and a labour market that is no longer generating inflationary pressure.
That sense of market calm will face a tangible test later this week. The Treasury Department is scheduled to sell $13 billion in 20-year bonds on Wednesday, followed by a $21 billion auction of 10-year Treasury Inflation-Protected Securities on Thursday. Given the intense focus among investors on the inflation outlook, the TIPS sale will provide a clear indicator of whether buyers actually share the anchored-inflation narrative that is currently driving nominal yields.
