Reading the Yield Curve Tea Leaves: What the 2-Year Treasury Yield Is and Isn’t Telling the Fed

Former JPMorgan Chase Global Chief Economist (Ph.D. in Economics) & Global Keynote Speaker

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As expected, the Federal Reserve kept interest rates unchanged in its May 7, 2025, policy meeting. It concluded unanimously that the risks of higher inflation and a higher unemployment rate prevented any action at this meeting. Two schools of thought emphasized this Hobsonian choice. On the dovish side, Fed Governor Waller, previously labeled a monetary hawk, has turned dovish and recently stated that he is increasingly concerned about the demand destruction from tariffs than the one-time inflationary impacts of tariffs. Given this scenario, Waller can envision the Fed acting sooner rather than later. Others, like former Boston Fed Governor Rosengren, worry that if tariffs increase prices and create supply shortages, lower interest rates may stimulate demand and exacerbate inflationary pressures.

Given this dilemma, we leave it to readers to decide which of these two former Fed officials makes the strongest case for easing rates sooner or waiting until later to act. Of course, this debate may soon become moot because at this time, the federal funds futures market estimates a 30.4% and 73.5% probability of a lower policy rate at the June 18, 2025, and July 30, 2025 FOMC meetings, respectively.

Market Signals

Some readers have asked us to clarify the signaling role of the 2-year U.S. Treasury yield through a nonpartisan lens. In other words, can the spread between the 2-year Treasury yield and the federal funds rate be used to prompt the Fed to raise or lower interest rates?

This request comes against the backdrop of comments by U.S. Treasury Secretary Scott Bessent, who recently pointed out the significance of the 2-year Treasury yield hovering below the federal funds rate. He interpreted this inversion as a clear market signal that the Federal Reserve should consider cutting interest rates as economic growth weakens. However, a broader consensus exists on Wall Street and among international organizations like the International Monetary Fund (IMF) that tariffs should slow U.S. and global economic growth. The message from Washington varies; on some days, it indicates that the economy is doing well, while on other occasions, it suggests that lower interest rates are needed to help boost the U.S. economy.

Our review of the economic literature argues overwhelmingly against the view that the 2-year Treasury yield should signal how the Federal Reserve should adjust the federal funds rate. A recent empirical study by the Federal Reserve of San Francisco (cited below) also supports the conventional perspective that the 2-year Treasury yield reflects the market’s expectations of future federal funds rates, which can fluctuate based on economic fundamentals. This research is based on the yield curve’s “Expectations Hypothesis.” By way of background, the “Expectations Hypothesis,” along with other theories of the yield curve, was the focus of my Doctoral dissertation that I completed nearly 40 years ago while working as an intern at the Board of Governors of the Federal Reserve in Washington, DC. It is reassuring that this theory remains actively discussed in financial markets!

Source: Federal Reserve Bank of San Francisco, "Treasury Yield Premiums"

The current spread between the federal funds rate and the 2-year Treasury yield is about -50 basis points. Interestingly, in September 2024, when the Fed lowered interest rates by 50 basis points, the spread was significantly wider at -126 basis points. Nonetheless, the reduction of rates at the time was met with outrage, as revealed by a Newsweek article entitled: “Federal Reserve rate cut sparks MAGA fury: Election interference.” From a nonpartisan perspective, we must ask why a 50-basis-point spread warrants an immediate rate cut, while the wider 126-basis-point spread in 2024 argued for no action back then? According to economic literature, the nonpartisan answer is that in both instances, the spreads reflected what the markets expected the Federal Reserve would do over the next two years and should not have determined whether the Fed should have lowered or kept interest rates unchanged.

As always, we leave it to the reader to decide whether the Fed should have reduced interest rates in September 2024 or at today’s FOMC meeting. Our sole contribution is that, irrespective of what one might think, the spread between the 2-year Treasury yield and the federal funds rate should not play a factor in determining what the Fed should or should not do!

Other factors that may help our readers decide are that in September 2024, the yearly change in the Consumer Price Index was 2.4%, and in April 2025, that figure remained at the same 2.4% level. The only difference is that today, the conventional view is that the existing tariffs imposed so far, if they stay, will lead to a one-time upward rise in inflation for each round of tariffs. In a world where new tariffs are being projected for semiconductors, drug prices, and foreign auto parts, we can expect several upward price adjustments if such actions come to fruition.

Of course, we invite readers to reach their conclusions because some believe tariffs are being used as a negotiation strategy and will soon disappear. In contrast, others, including corporate CEOs like Jim Farley (Ford Motor), have stated that tariffs will likely remain in place over the next three years. As evidence of Farley’s conviction, Ford announced that it would raise the price of some models produced in Mexico by $2,000, even though that would not be enough to offset its $2.5 billion cost increase due to tariffs. Not surprisingly, the data already suggests that used vehicle prices, which are often a substitute for new cars, are rising by 4.9% from levels a year ago! For these reasons, many S&P 500 companies have suspended offering earnings guidance, claiming that the levels of uncertainty make providing such guidance problematic.

Source: The U.S. Bureau of Labor Statistics

What About Inflation Expectations?

Beyond signaling interest rate expectations, the 2-year Treasury yield does provide insights into the market’s inflation expectations. Investors often compare yields on nominal Treasuries with those on Treasury Inflation-Protected Securities (TIPS) to assess anticipated inflation. The difference, known as the breakeven inflation rate, reflects the market's inflation outlook.

Studies have shown that short-term breakeven rates, such as the 2-year, can be volatile and influenced by various factors, including investor sentiment and market liquidity. However, they still serve as valuable tools for understanding market expectations about inflation and, by extension, potential monetary policy responses.

Summary and Concluding Thoughts

Our nonpartisan analysis finds that the 2-year Treasury yield remains vital for interpreting market expectations about the Federal Reserve's future monetary policy actions. While its movements may provide important insights, it's essential to recognize its role as a reflection of market sentiment rather than a directive for policy action.

Policymakers must balance these signals with comprehensive economic analyses to make informed decisions that promote sustainable economic growth. In the latest FOMC policy decision announced on May 7, 2025, the FOMC opted to keep its policy rate unchanged. We leave it to the reader to decide whether they made the right decision. Nevertheless, our contribution remains that this decision should have been determined by the available economic fundamentals and not by the spread between the federal funds rate and the 2-year Treasury yield!