Is the bond market pricing in a Federal Reserve policy mistake?

　　

Imagine this scenario: In early October, someone with a crystal ball tells you that the upcoming September CPI data will come in higher than market expectations, and the Producer Price Index (PPI) will rise 1.3% for the month, well above the forecast of 0.5%. In addition to this negative inflation news, the person also mentions that inflationary pressures are still brewing, and crude oil prices will climb by $10 in the first two weeks of the month. With this prediction, where do you think the yield on the 10-year US Treasury would be? As a reference: On October 1,

　　After the CPI data was released on October 14, the 10-year Treasury yield soared and touched 5.33% within minutes. However, just a few days later, yields retreated sharply to 5.03%. The 30-year Treasury yield experienced a similar decline. Despite the inflation data coming in stronger than expected, the bond market instead saw a rally.

　　Mohamed El-Erian, former CEO of Pacific Investment Management Company (PIMCO) and renowned bond expert, posed this obvious question on X:

　　Despite CPI and PPI inflation data both coming in higher than expected, why are US Treasury yields falling?

　　He offered two logical explanations. This article will interpret his two AI-related analyses and supplement with two additional viewpoints of our own. The most important point is: The bond market may have started pricing in a risk—namely, that the Federal Reserve could be forced into a policy mistake.

　　Explanation 1: Money flows out of tech stocks into safe-haven assets

　　El-Erian’s first driving factor is the shift out of previously soaring, now pressured technology stocks, triggering safe-haven buying.

　　Many semiconductor stocks continued to weaken. During the period from October 1 to the PPI data release on October 15, the SOX semiconductor index fell by nearly 20%.

　　The Nasdaq, which has a high weighting in semiconductors, fell in tandem. Overseas markets also saw steep declines, including the Korea Composite Stock Price Index (KOSPI) and the Nikkei Index in Japan, both of which are tech-heavy indices.

　　As shown in the chart below, since October 1, the Healthcare sector (XLV), Consumer Staples (XLP), and other previously sold-off value sectors have rallied, while the Technology sector (XLK) has moved in the opposite direction. This rotation is essentially an internal safe-haven shift within the equity market, but El-Erian believes it also sparked some Treasury bond buying.

　　Additionally, El-Erian notes that the most vulnerable market segments are experiencing credit stress. For example, large data center service provider CoreWeave saw its bond yield surge from 9% to 15%. Since investors are demanding such high yields on CoreWeave and its peers’ bonds, the market is worried that CoreWeave may become the “canary in the coal mine” in the AI craze (serving as an early warning signal).

　　Such credit risk events often prompt capital to move from corporate bonds into US Treasuries—a classic safe-haven behavior.

　　Explanation 2: Is technology still the engine of economic growth?

　　El-Erian’s second point has broader macro implications: AI-related capital expenditure has been a core driver of economic growth. If investors are no longer willing to fund AI expansion projects at all costs, and enterprises themselves cannot shoulder the investment, does this mean the outlook for economic growth will weaken as a result?

　　Charu Chanana of Saxo Bank stated:

　　Investors are no longer willing to finance AI infrastructure expansion regardless of cost.

　　With the 10-year US Treasury yield breaking above 5% and some AI-related credit spreads reaching “junk bond” levels, the cost of financing data centers has surged. Tightening AI capital expenditure implies slower GDP growth, and lower growth expectations dampen inflation expectations, ultimately pushing long-term yields down.

　　Explanation 3: Short-covering and powerful demand signals

　　Our first addition to El-Erian’s views: short-covering. At the start of October, the bond market overwhelmingly bet on higher yields.

　　Bloomberg, citing CFTC data: For the week ending September 22, asset managers added over 100,000 net short contracts on 10-year Treasury futures—the largest weekly short-position build since 2023. In addition, in the 14 trading days in late September, open interest on 10-year Treasury futures rose in 13 and 5-year Treasury futures increased in 11 out of 12 sessions. All this shows that as yields rose, the market kept building new short positions.

　　The auctions of 10-year and 30-year Treasuries held on October 7–8 seemed to signal this reversal in advance. Many investors expected tepid demand for newly issued bonds, but the opposite happened. From our commentary piece:

　　Wednesday’s 10-year Treasury auction issued $39 billion, with a high yield of 5.300%, 1.7 basis points below market expectations—meaning the auction was much stronger than anticipated. The 30-year, $22.5 billion auction the next day was similar. As shown in the box plot below (courtesy of ExanteData), the bidding data were both well away from historic norms. The bid-to-cover for the 10-year Treasury was 2.77 versus a 12-month average of 2.51, a new high for the last 50 auctions; the 30-year bid-to-cover was 2.54, historical median 2.40, at the top end for the past 50 auctions.

　　The participation rate of primary dealers may be the most important auction indicator. Primary dealers are required to take up any unsold Treasuries. If their take-up is high, it means the auction was weak and Wall Street is being forced to hold inventory. In these auctions, primary dealers took only 2.5% of the 10-year issue—a record low; for the 30-year, only 6.8%. Indirect bidders (mainly foreign central banks and domestic institutions) took down 80.3% and 72.3% respectively, both well above historical averages.

　　From these auctions, it is obvious that primary dealers barely had to step in, showing that there is genuine, long-term demand for Treasuries at current yield levels. Although bond prices did not immediately surge upon these strong auction results, this sounded a warning bell for short sellers: Above 5%, market demand is quite robust. Strong buying triggered short-covering. With crowded short positions, this covering looped back on itself, forcing even more short-covering.

　　Explanation 4: The bond market senses a risk of policy error

　　The bond market may have started to believe that this month’s higher-than-expected inflation data will force the Fed to continue raising rates, rather than cut them—ultimately leading to a policy mistake.

　　Yield-curve moves over the past two weeks back this up. On October 7, the 2- and 10-year Treasury yield spread stood at 57 basis points. After the CPI and PPI data were published, the spread narrowed to 32. Over two weeks, the spread contracted by 25 points, with most of the change happening on the day the inflation data dropped.

　　When all yields fall, and the long end drops more than the short end, this pattern is called a “bull flattener.” If the market expects the Fed to keep tightening even as the economy weakens, money buys the long end, flattening the curve. Conversely, if the market fears out-of-control inflation, it steepens via a “bear steepener.”

　　The short end of the curve prices the odds of Fed hikes; the long end prices in the economic consequences of those hikes.

　　Reasons to fear a policy mistake

　　There are several reasons why the bond market worries about Fed policy going astray:

　　First, this round of inflation is largely a supply shock. The surge in gasoline and diesel prices is linked to geopolitical tensions with Iran, not overheated domestic consumption. The Fed cannot pump more oil, but it can suppress demand for everything else.

　　Second, the labor market has weakened. September nonfarm payrolls added just 29,000 jobs, with downward revisions totaling 60,000 in prior months. The unemployment rate climbed to 4.2%, real incomes are flat or slightly declining, and there is almost no evidence of a wage-price spiral fueling inflation.

　　Third, consumers are under pressure. The latest retail sales came in at 0.8%, better than expected, but growth was driven mainly by gasoline spending. The “control group” retail sales, used by the Bureau of Economic Analysis to calculate GDP, rose only 0.1%. Essentially, rising oil prices are squeezing consumer spending in other areas.

　　Fourth, by the Fed’s own calculations, monetary policy is already restrictive. After the September rate hike, the federal funds rate is now 3.75%–4.00%, above the Fed’s long-term neutral estimate of 3.20%. The Fed’s latest Summary of Economic Projections (SEP) “dot plot,” combined with officials’ comments, suggests one or two more hikes are quite possible.

　　Fifth, financial conditions are tightening. The 10-year Treasury yield is above 5%, 30-year mortgage rates are near 7.50%, the dollar is at an 18-month high, and credit spreads are widening—these factors alone are tightening the economy on behalf of the Fed. Further hikes in the fed funds rate would tighten conditions even further.

　　The hawkish rationale

　　Objectively speaking, there is reason for Fed hawks to keep raising rates. The latest CPI shows widespread price increases in goods and services, core PCE is near 3%; and most crucially, inflation has run above the Fed’s target for more than five years. The Fed has reason to fear inflation expectations will become unanchored.

　　But in bond market pricing, what matters isn’t just whether inflation is too high at present—or what inflation’s past level was—but where inflation is headed, and whether the Fed’s medicine against inflation may carry a side effect of recession, beyond fighting price rises.

　　Conclusion

　　When inflation data is running hot but bond yields fall, this is not a contradiction. Multiple factors are at play: safe-haven buying as money flees tech stocks, a loss of confidence in AI as a growth engine, crowded short positions being closed, and robust demand for Treasuries among allocators.

　　In our view, the most important signal is that the market fears the Fed is confronting an energy-driven inflation shock while inflation remains persistently high, and opting to keep tightening monetary policy during an economic slowdown. The yield curve’s shape and movement in the long end provide an excellent weather vane for what comes next.

Editor: Guo Jian