How Rising Interest Rates Are Reshaping the Bond Market and Federal Reserve Policy

The December 2025 FOMC meeting marked the third consecutive quarter‐point rate cut, bringing the federal funds rate down to 3.50%–3.75%, the lowest since November 2022[3]. The vote was split 9-3, with two members preferring no change and one wanting a 50 bps cut, underscoring persistent internal disagreement about policy direction [3]. Forward projections suggest one further quarter-point cut in 2026, with officials awaiting more definitive signs of inflation easing [3].

Long‐term yields have not followed the steep drop in short rates transmitted through Fed cuts: the 10-year Treasury yield remains in a narrow range around 4.00%–4.25%, influenced by expectations of sticky inflation and resilient economic expansion [1]. Core inflation data indicate rates of ~2.6%–3.0%, while headline inflation has similarly held above target, though recent readings are somewhat mixed and potentially distorted by delayed data releases from the government shutdown [1].

Fiscal dynamics are adding complexity. The OBBBA is projected to increase budget deficits meaningfully through 2034—by $4.1 trillion over FY2025–34 under current provision, and potentially up to $5.0 trillion if many temporary provisions become permanent [2][3]. This additional borrowing demand may force higher yields on long maturities as the Treasury increases issuance, especially if investors demand greater compensation for risk [1][2]. However, recent U.S. Treasury strategy favoring shorter-term bill issuance could dampen yield pressure in the near term [1].

For investors, the current environment offers income opportunities: short yields have fallen, while longer yields remain relatively high—creating favorable risk/reward trade-offs. Yet the flatness or modest steepness of the yield curve (approximately 10-year yield ≈ 0.67 pp above 2-year, versus the historical average of ≈ 0.80 pp) means term premia are compressed and interest rate risk looms. Diversifying across maturities and credit sectors, and being selective about exposure to inflation or policy risk, are prudent strategies [1].

Open questions remain: Will inflation fully return toward 2% or linger above target? How patient will the Fed be in waiting for stronger labor-market evidence? How large will the fiscal drag be from OBBBA and related policies? Finally, what is investors’ appetite for long-duration risk in tense fiscal and political settings?