As Federal Reserve Cuts Rates, Some See Path to Higher Yields

The Federal Reserve has cut interest rates for the first time in more than a decade. Inflation remains stubbornly low. And government bond yields are negative in Europe.

The conditions are firmly in place for U.S. Treasury yields to stay low, pushing down interest rates for a range of borrowers. Yet a path remains for borrowing costs to move higher, according to investors and analysts. They say that path exists precisely because the Fed is now clearly open to rate cuts.

In the short term, lower interest rates should drag down yields on shorter-term Treasurys, which are particularly sensitive to changes in monetary policy. But over the medium to long term, easy-money policies from the Fed could potentially drive up inflation, which is a main threat to the value of longer-term bonds.

Policy makers led by Fed Chairman Jerome Powell reduced their benchmark interest rate by a quarter of a percentage point on Wednesday. Their goal in part is to stoke inflation, which has surprised officials by remaining tepid despite a decadelong economic expansion and an extremely tight labor market.

Already, there are signs investors think there is at least a chance that a rate cut could spur long-awaited consumer price increases. The yield on the 10-year Treasury note, which rises when the price of the bond falls, has recently climbed above 2.0% from 1.95% earlier this month.

A key driver of that move has been an uptick in inflation expectations, with the 10-year break-even rate, derived from the extra yield investors demand to hold standard 10-year Treasurys over 10-year Treasury inflation-protected securities, rising to around 1.8% from 1.6% in June.

“As you see TIPS break-evens start to accelerate, that could, for sure, put some pressure on the back end of the Treasury curve,” says Michael Lorizio, a senior trader at Manulife Asset Management.

New data on Tuesday showed one of the Fed’s preferred measures of inflation rising in June a little more than economists had expected. While what is known as the core personal-consumption expenditures price index was up only 1.6% from a year earlier, below the Fed’s 2% target, some analysts expect that number to rise going forward, thanks in part to some easy-to-beat readings from the past 12 months.

Even so, most analysts don’t expect any large increase in Treasury yields. For Mr. Lorizio, a notable increase in the 10-year yield would still put it no higher than around 2.2%—a level below where it stood for all of 2018.

Others point to a series of events needed to push the 10-year yield to the mid-2% range. To begin with, yields in Europe would likely need to rise off their record lows.

For that to happen, the U.S. and China might need to reach a trade deal. That could boost the Chinese economy as well as growth in parts of Europe including Germany, which is a big exporter to China. It would also help if the U.K. avoided a “hard Brexit,” despite recent signs that such an economically disruptive departure from the European Union is becoming more likely.

Even then, some believe it would take more to get investors back to where they were last fall, when the 10-year yield was above 3% and rising.

One obstacle to higher inflation is a stubbornly strong dollar, some analysts say. On its own, rate cuts from the Fed might be expected to weaken the dollar by making the currency less attractive to yield-seeking investors. That, in turn, could boost inflation by making imports more expensive. Other central banks, however, are also promising monetary stimulus, helping to preserve the relative appeal of the U.S. currency.

In what for the Fed is a potentially bad sign, the European Central Bank and the Bank of Japan have themselves taken extraordinary measures to boost inflation with little success, says Zhiwei Ren, a portfolio manager at Penn Mutual Asset Management.

Still, yields could turn higher if a progressive Democrat wins the party’s nomination for president next year and looks to have a good chance of winning the general election while promising ambitious, and potentially inflationary, spending policies, he adds.

“It’s going to take political actions,” he says.

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Write to Sam Goldfarb at sam.goldfarb@wsj.com

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