How Policy Moves Impact Yield Curves

When the Fed hikes rates, short-term Treasury yields respond directly—but long-term yields often lag or move less. This asymmetry creates the curve flattening that preceded every recession since 1970 (Federal Reserve Bank of Cleveland, 2024). During the 2022-2023 tightening cycle, the Fed raised the fed funds rate by 525 basis points, but the 10-year Treasury yield rose only about 250 bps over the same period. The practical point: policy moves don't shift the entire curve in parallel—they reshape it.

The Short End: Directly Tied to Fed Funds

Short-term Treasury yields (3-month, 6-month, 2-year) track the fed funds target closely. The mechanism is direct:

Fed sets target → Money market rates adjust → Short Treasuries reprice

The 3-month Treasury bill typically trades within 10-25 bps of the effective federal funds rate. When the FOMC raises the target range by 25 bps, short-term yields follow within hours. The 2-year Treasury yield reflects the current fed funds rate plus market expectations for policy over the next two years.

Current example (December 2025):

• Fed funds target: 4.25-4.50%
• 3-month T-bill: 4.32%
• 2-year Treasury: 4.18%

The 2-year trading below the fed funds rate signals that markets expect rate cuts over the next 24 months. The point is: the short end tells you where policy is (current fed funds) and where it's heading (embedded expectations).

The Long End: Expectations, Term Premium, and Supply/Demand

Long-term yields (10-year, 30-year) respond to Fed policy indirectly. Three factors drive long rates:

1. Expected average short rates over the bond's life

If markets expect the Fed to average 3.5% over the next 10 years, this component pulls the 10-year yield toward that level—regardless of where the current fed funds rate sits.

2. Term premium

Investors demand compensation for locking up money for longer periods. This premium has ranged from -50 bps to +200 bps historically (Adrian, Crump, and Moench, 2013). Currently, term premium estimates are +30 to +60 bps, reflecting uncertainty about inflation and fiscal trajectories.

3. Supply and demand dynamics

Treasury issuance, foreign buyer appetite, pension fund duration matching, and Fed holdings (QE vs QT) all affect long-term yields independently of rate policy. When the Fed accelerated QT in 2024, 10-year yields faced upward pressure from reduced Fed demand.

The durable lesson: the Fed controls the short end precisely but influences the long end only indirectly. Long rates can fall during a hiking cycle if growth expectations deteriorate faster than policy tightens.

Rate Hikes Typically Flatten the Curve

When the Fed tightens, short rates rise more than long rates. This creates curve flattening:

Hiking cycle → Short rates rise directly → Long rates rise less → Spread compresses

Sources: Federal Reserve, Bloomberg

Why this matters: Flattening signals that markets believe current policy is restrictive enough to eventually slow growth and force the Fed to reverse course. The 2022-2024 inversion—with the 2s10s spread reaching -108 bps at its deepest—reflected expectations that 5.25-5.50% fed funds was unsustainably high.

Rate Cuts Typically Steepen the Curve

When the Fed eases, short rates drop faster than long rates:

Cutting cycle → Short rates fall directly → Long rates fall less → Spread widens

During the 2019-2020 cuts, the Fed lowered the target from 2.25-2.50% to 0.00-0.25%—a 225 bp reduction. The 2-year yield fell from 2.25% to 0.15%, while the 10-year fell from 2.40% to 0.55%. Result: the curve steepened by approximately +120 bps.

The mechanism differs from hikes:

1. Short rates follow the Fed cut immediately
2. Long rates reflect expectations that the Fed eventually normalizes policy
3. Recession fears during cuts often keep long rates from falling as much (growth expectations worsen before improving)

The test: When the curve steepens from deeply inverted territory, it often signals recession has begun or is imminent—not recovery. The "bull steepening" (all rates falling, shorts faster) preceded recessions in 1990, 2001, 2008, and 2020.

Curve Shapes and What They Signal

Normal curve (upward sloping, 2s10s spread +50 to +150 bps):

• Economy expanding at moderate pace
• Fed policy near neutral
• Positive term premium reflecting growth confidence

Flat curve (2s10s spread near 0):

• Often transitional between normal and inverted
• Fed tightening cycle approaching peak
• Growth slowing but not yet recessionary

Inverted curve (2s10s spread negative):

• Fed policy restrictive relative to neutral
• Markets expect eventual cuts
• Historical recession predictor (12-24 month lead time average)

Steep curve (2s10s spread above +200 bps):

• Fed policy accommodative
• Often during or after recessions
• Banks profit from borrow-short/lend-long spread

The practical point: the shape tells you where you are in the policy cycle. Steep curves occur at cycle troughs, flat and inverted curves at peaks.

Example: 100 Basis Point Hiking Cycle Impact

Suppose the Fed hikes by 100 bps over 9 months (four 25 bp increases). Here's the typical impact:

Starting conditions:

• Fed funds: 3.00%
• 2-year yield: 3.25%
• 10-year yield: 4.00%
• 2s10s spread: +75 bps

After 100 bp hike:

• Fed funds: 4.00%
• 2-year yield: 4.00% (+75 bps)
• 10-year yield: 4.30% (+30 bps)
• 2s10s spread: +30 bps

What happened: The 2-year yield rose 75 bps, tracking most of the fed funds increase but pricing in some expectation of future cuts. The 10-year rose only 30 bps because:

1. Long-run rate expectations stayed anchored near neutral (around 2.5-3.0%)
2. Growth expectations softened with tighter policy
3. Term premium remained stable

Result: curve flattened by 45 bps (spread compressed from +75 to +30).

The durable lesson: hikes hit the short end harder. In aggressive tightening cycles, the 2-year can rise by +300 to +400 bps while the 10-year rises only +100 to +200 bps.

Monitoring the Curve: A Practical Framework

Essential spreads to track

Key thresholds

• 2s10s below -50 bps: Deep inversion, recession signal strong
• 2s10s between -50 and +50 bps: Transitional, watch direction
• 2s10s above +100 bps: Accommodative policy, early cycle

Weekly routine

1. Check the 2s10s spread on FRED (takes 30 seconds)
2. Note the direction of change over the past month
3. Compare to the fed funds target to assess policy stance
4. If inverted, track the duration of inversion (longer inversions historically precede deeper recessions)

Common Mistakes and How to Avoid Them

Mistake 1: Expecting parallel shifts

Investors often assume rate changes move all yields equally. In reality, the short end moves most, the long end least. Duration positioning matters differently across the curve.

Mistake 2: Ignoring term premium

The 10-year yield can rise even during a cutting cycle if term premium expands (due to fiscal concerns, inflation uncertainty, or reduced foreign buying). Term premium isn't observable directly—it's estimated—but it explains why long yields sometimes defy policy expectations.

Mistake 3: Trading inversions immediately

The curve inverted in October 2022 but the economy continued growing through 2024. Inversions predict recessions with long and variable lags. Using inversion as a timing signal typically leads to premature positioning.

Your Next Step

Pull up the FRED chart for T10Y2Y (10-year minus 2-year spread) and note today's reading. Compare it to the +80 bps long-run average. If the spread is negative or below +50 bps, the curve is flat or inverted—signaling late-cycle conditions. Use this as your baseline before interpreting any Fed policy announcement.

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Related: Federal Reserve Dual Mandate Explained | Measuring Market-Implied Policy Expectations | Understanding Treasury Yield Curve Shapes