Zheshang: How should we view the 10-year U.S. Treasury yield breaking above 5%?

Zheshang released a research report stating that after the Fed's September rate hike was implemented, U.S. Treasury market conditions stabilized in the short term, but the problems causing U.S. Treasury yields to rise have not been fundamentally resolved, and the possibility that U.S. Treasury yields may continue to rise substantially thereafter and transmit risks to other financial markets such as U.S. equities cannot be ruled out. The domestic bond market showed strong resilience in September, and the fourth-quarter and year-end rally is worth anticipating. Zheshang's main views are as follows: How to understand the FOMC meeting 1) The Fed raised rates as expected at its September FOMC meeting, and the relatively hawkish policy signal exceeded market expectations. This meeting may differ from previous ones: for major financial assets, a rate hike may actually be better than no hike. 2) On September 17, the Fed held its FOMC meeting and announced that it would raise the federal funds target rate range from 3.50%-3.75% to 3.75%-4.00%, the first hike since July 2023, with the policy action in line with market expectations. Notably, the meeting passed by a unanimous 12:0 vote, reflecting to some extent a strengthening trend of hawkish voices within the Fed. 3) From the economic projection materials, compared with the forecasts at the June meeting, the September meeting presented an economic outlook of steady improvement, a decline in the unemployment rate, and a slight rise in inflation. However, at the level of the federal funds target rate forecast, the September meeting's projection rose further from 3.8% to 4.1%. Considering the 3.75%-4.00% policy rate range after the hike, this points to one potential additional hike within the year. 4) The dot plot more clearly reflects potential rate hike expectations. Among the 18 members who made projections, only 2 believed that the target rate range would remain unchanged at 3.75%-4.00% by the end of 2026, 12 believed there would be another 25BP hike, and 4 believed there would be a further 50BP hike. The relatively positive news is that the members do not believe the hiking cycle will last too long. The economic projection materials show that the federal funds target rate in 2027 is unchanged from 2026, both at 4.1%, and the dot plot also shows that forecasters are roughly evenly split between the 4.00%-4.25% range and the 4.25%-4.50% range. 5) This time the Fed finally began its rate hike action, and Warsh also clearly stated at the press conference that inflation is too high and has lasted too long, that the latest data do not show signs of a trend decline in underlying inflation, and that current financial conditions are not restrictive. This constitutes the core basis for the rate hike. As for Warsh, it was previously pointed out that the key is not what he says but what he does. This time the Fed raised rates accordingly, and combined with the dot plot and the anti-inflation signal conveyed by Warsh, his hawkish persona may be revised to some extent. 6) This meeting may differ from previous ones, and the impact of a rate hike on major financial assets may be better than no hike. Generally speaking, a Fed rate hike means tighter financial conditions and is somewhat bearish for major assets such as U.S. equities, gold, and U.S. Treasuries. But this meeting may be different from the past: a rate hike is instead a good thing, with the core reason being differences in the underlying driving logic of major assets. 7) Since August, U.S. Treasury yields have risen rapidly, becoming the main reason affecting price changes in other assets. At a deeper level, the reasons for the continued rise in U.S. Treasury yields may come from two major aspects: first, concerns about U.S. fiscal discipline and sustainability brought about by continued U.S. fiscal expansion; second, concerns about monetary discipline over whether the Fed, represented by Warsh, can maintain independence under pressure from the Trump administration. Warsh's previous behavior of being "hawkish in name but dovish in reality" may have damaged monetary discipline to some extent, while this time the Fed withstood pressure from the Trump administration to push through a rate hike, which may prove that the Fed still maintains a considerable degree of independence. While demonstrating a tough stance against inflation and helping to inflation expectations, it is also positive for alleviating the problem of investors demanding a higher term premium due to the lack of monetary discipline. How to view the subsequent U.S. Treasury market 1) After the rate hike was implemented, U.S. Treasury market conditions stabilized in the short term, but the root problems causing U.S. Treasury yields to rise have not been properly resolved. Subsequently, the Fed may also face a dilemma in which U.S. Treasury yields may rise whether it hikes or not. There may still be room for U.S. Treasury yields to rise by 50-100BP, and the contagion risk to other assets such as U.S. equities should not be ignored. 2) Before the Fed meeting, the 10-year U.S. Treasury yield briefly broke through the 5.00% integer mark, further intensifying market concerns. After the Fed raised rates as expected, the market chose to temporarily believe in Warsh's and the Fed's determination to fight inflation and safeguard the Fed's independence, and U.S. Treasury yields fell significantly, easing short-term U.S. Treasury risk somewhat. 3) But from a longer time horizon, the fundamental problem of U.S. Treasuries may not lie with the Fed. If long-term problems are not resolved, the risk of a trend rise in U.S. Treasury yields may not be completely ruled out. In an extreme scenario, the 10-year U.S. Treasury yield may still have potential upside room of 50-100BP. 4) First, U.S. fiscal problems may already be beyond remedy. Total U.S. national debt has now exceeded $40 trillion, and the enormous debt scale also brings a heavy interest expense burden. The latest U.S. Treasury Department data show that, as of the first 11 months of the U.S. 2026 fiscal year, the U.S. fiscal deficit had reached $1.97 trillion, and net interest expense had reached $1.02 trillion, making it the second-largest expenditure item after Social Security. Considering that the "One Big Beautiful Bill" mainly promoted by Trump will continue to operate, future U.S. fiscal deficit pressure may further intensify, and the continued weakening of fiscal discipline constitutes the core reason for the trend rise in U.S. Treasury yields. 5) Second, the inflation problem may not be a one-off shock. In the current U.S.-Iran conflict, Iran may be the side with more dominance. For the Trump administration, whose main narrative logic is a narrative of victory, it may now be caught in a dilemma. Moving forward, without a substantial troop increase, it may be difficult to form effective military suppression of Iran, while high domestic anti-war sentiment may not support expanding the scale of military operations. Retreating by hastily admitting defeat and directly withdrawing would undoubtedly cede Iran's dominant position in the Middle East and would become a governing stain on the Trump administration, negatively affecting subsequent Republican electoral prospects. Caught in this dilemma, the global mismatch between crude oil supply and demand persists, and as countries' crude oil reserves are gradually depleted, a broader oil price shock may occur later, and the inflation problem may face a long-term risk of heating up. 6) Third, whether or not the Fed chooses to raise rates subsequently, U.S. Treasury yields may continue to rise. If the Fed's rate hikes are insufficient while the Middle East issue evolves into a long-term problem, inflation may continue to rise and further spread to other industries. At that time, U.S. Treasury yields may continue to rise under the influence of multiple factors such as fiscal missteps and runaway inflation. If the Fed's rate hikes exceed expectations, this rate hike means the start of a new hiking cycle, and as the central policy rate rises steadily, U.S. Treasury yields may likewise follow a potential path of rising in tandem. 7) Further extrapolation suggests that if U.S. Treasury yields continue to rise, U.S. equities, represented by the technology rally, may be the first to face a shock. On the one hand, continued rate hikes will further raise the risk-free rate, directly pressuring technology stock valuations. On the other hand, leading technology companies continue to raise funds through bond issuance and other channels to avoid falling behind in the technology arms race. Continued rate hikes will significantly increase their financing costs, and while impacting their actual operating performance, will also further narrow investors' imaginative space for their future narratives. Under the reverse "Davis double-kill" pressure brought by continued rate hikes, investors' concerns about the bursting of the U.S. technology rally bubble may intensify and gradually selling behavior, ultimately producing a long-tail risk scenario of simultaneous declines in U.S. equities and bonds in a process of self-fulfilling expectations. The slow bull market in Chinese bonds remains unchanged 1) In September, the domestic bond market "not falling when it should have fallen" further highlighted the resilience of the market. The decline in bond fund duration instead constituted a potential positive. The potential risk of a Fed rate hike to the technology rally should not be ignored. Under the stock-bond valuation comparison, the cost-effectiveness of bonds may be further reflected, and the fourth-quarter and year-end bond market rally may be worth anticipating. 2) Under calendar effects, since 2020 the bond market has historically faced headwinds in September. The 10-year Chinese government bond yield fell slightly only in September 2024; in all other years, yields rose without exception, with an average increase of nearly 9BP. The main drivers include concentrated increased supply of government bonds, marginal tightening of liquidity, and rising expectations for growth-stabilizing policies. 3) After experiencing a rally from late July to late August 2026 in which Chinese government bond yields steadily declined, market profit-taking sentiment increased again. At the same time, considering potential bearish disturbances such as calendar-effect headwinds and possibly faster government bond issuance, the bond market may have internal adjustment momentum. Also, from the perspective of bond fund duration, bond fund duration continued to decline after peaking in mid-August. But looking ahead, the bond market showed unexpected resilience. The 10-year Chinese government bond yield rose only slightly at the end of August but then quickly fell back, and at other times continued to maintain low-level fluctuations. Despite multiple bearish factors, the bond market "not falling when it should have fallen" may reflect more investors' bullish trading approach of adding positions at low levels. After the decline in bond fund duration, it instead provides more room for potential future duration extension, indirectly becoming a bullish factor and providing a solid foundation for a potential breakthrough in the fourth-quarter bond market. 4) Under the stock-bond valuation comparison, bonds may be more cost-effective. Previously, through a review of stock and bond market conditions over the past year, it was proposed that bonds have returned to the ranks of strong assets. After the Fed turned to rate hikes, although the short-term U.S. equity market recovered somewhat, the pressure from the reverse "Davis double-kill" should not be ignored from a long-term perspective. In addition, given the high correlation of global stock markets, if tail risk occurs, the safe-haven value of domestic bonds may be further highlighted. 5) On September 18, cash bond yields fell across the board, with 10-year and 30-year Chinese government bond yields approaching previous lows. There may have been some degree of front-running trading, reflecting the current bond market sentiment of wanting prices to rise. Looking to the next stage, one may be more optimistic about the fourth-quarter bond market. Under multiple potential positives such as accommodative monetary policy, the stock-bond valuation comparison tilting further toward bonds, and the reshaping of the asset shortage logic, the bond market may be expected to stage a buildup-and-breakout rally. Risk warning Macroeconomic policy may undergo marginal changes beyond expectations, which may lead to changes in asset pricing logic and cause adjustments in the bond market; institutional behavior is somewhat unpredictable, and when institutional behavior becomes highly convergent and forms negative feedback, it may cause adjustments in the bond market.