The 2-year U.S. Treasury yield posts its largest drop since August: Is the market pricing in a shift by the Federal Reserve toward rate cuts?

On July 14, the U.S. bond market went through a sharp repricing.

Data released by the U.S. Bureau of Labor Statistics showed that in June, the Consumer Price Index (CPI) fell 0.4% month over month. This was the first time it had turned negative since May 2020 during the COVID-19 pandemic, and it was also the first monthly decline in six years. On a year-over-year basis, June CPI gains eased to 3.5%, significantly lower than May’s 4.2%. Core CPI—excluding food and energy—was flat month over month and rose 2.6% year over year. Both figures came in below market expectations.

After the data was released, the 2-year U.S. Treasury yield—most sensitive to monetary policy—plunged intraday by as much as 14 basis points to 4.14%, marking the largest single-day drop since August last year. By the close, the 2-year U.S. Treasury yield was 4.193%, down 7.76 basis points on the day. At the same time, the 10-year U.S. Treasury yield fell 2.61 basis points to 4.591%, while the 30-year U.S. Treasury yield edged down slightly by 0.11 basis points to 5.104%.

The steep decline in short-end yields reflects that market expectations for the Federal Reserve’s policy path over the next 6 to 24 months are undergoing a profound shift.

How cooling CPI changes rate expectations

The hotter-than-expected cooling in June inflation was driven primarily by a sharp drop in energy prices. Data showed that in June, gasoline prices fell 9.7% month over month, while overall energy prices fell 5.7% month over month, the largest monthly decline since April 2020. The decline in energy prices effectively offset increases in other category indexes such as housing and food.

Before this, market concerns about inflation were mainly focused on three areas: the AI investment boom could drive demand overheating; escalating Middle East tensions could push up energy prices; and tariff policies could affect commodity prices. However, the June data shows that inflation is moving closer to the Federal Reserve’s 2% target direction. The year-over-year core CPI increase fell from 2.9% in May to 2.6%, indicating that underlying inflation pressures are easing.

The direct impact of cooling inflation was a sharp drop in market expectations for Fed rate hikes. According to data from the CME FedWatch tool, the probability of a July rate hike had once approached 50% before the data release, then plunged to 15.5% after the data was released. The probability of keeping rates unchanged rose to 84.5%. However, the market still expects the Fed may take action in September; the combined probability of a 25-basis-point or 50-basis-point hike in September is 57.8%.

The Fed’s hawkish posture and the bond market’s dovish repricing

On the very same day the CPI data was released, Fed Chair Kevin Wosch delivered his semiannual monetary policy testimony to the House Financial Services Committee. The stance of the newly appointed Fed chair was quite tough—he stated clearly in his written testimony that, “not one member of the Committee will tolerate inflation staying unacceptably high for a prolonged period,” and that the Fed has “zero tolerance for persistently high inflation.”

Wosch emphasized that one should not conclude that the problem is already solved just because inflation improved in a single month. He also said the Fed has two policy tools—interest rates and the balance sheet—and that how those tools will be used in the future will be determined based on economic data. Notably, Wosch did not provide any hints about a rate path, contrary to what the market hoped for.

These remarks created a divergence worth watching: Fed officials signaled hawkishness, emphasizing policy discipline and that the inflation target would not change; meanwhile, bond market traders bet that monetary policy will ultimately turn toward easing, driven by inflation trends, changes in the labor market, and pressures on economic growth.

Nonfarm payrolls data provided supporting evidence. The figures released in early July showed that in June, nonfarm payrolls added only 57,000 jobs, far below market expectations, and the prior value was revised down by 74,000. Although the unemployment rate fell to 4.2%, part of the reason was that the labor force participation rate dropped to 61.5%—more people exited the labor force rather than finding jobs. The marginal weakening in the job market provides fundamental support for easing expectations.

Markets typically adjust expectations ahead of the Fed. Even though pricing in the interest rate futures market reflects holding rates steady in July, the probability of at least one rate hike before year-end still remains around 70%. What the bond market is trading is not that the Fed has already determined it is entering a rate-cut cycle, but rather that the likelihood of a policy shift is rising.

Signals released by changes in the yield curve

One important characteristic of this round of yield changes is that the decline is much larger at the short end than at the long end. The 2-year U.S. Treasury yield fell 7.76 basis points, while the 30-year fell only 0.11 basis points. As a result, the spread between the 2-year and 10-year Treasuries widened; as of July 15, the 2s10s spread had widened to about 39.6 basis points.

This “short-end decline and curve steepening” shape usually points to two possible macro narratives.

The first narrative is that a “soft landing” is again becoming the market consensus. If inflation keeps cooling and the economy does not fall into a recession, the Fed will have room to cut rates. The drop in short-end yields reflects fading rate-hike expectations, while the long end staying relatively stable indicates the market is not pricing in a deep recession. This is precisely the hallmark of the “soft landing” trade—market participants believe the Fed can ease policy without triggering an economic collapse.

The second narrative involves a liquidity logic for risk assets. Falling interest rates typically affect risk assets through two channels: first, lower risk-free rates increase the relative attractiveness of risk assets; second, improved expectations of easing enhance the dollar liquidity environment and boost overall risk appetite.

After the July 14 data was released, this logic was validated across multiple markets. All three major U.S. stock indexes closed higher. The S&P 500 rose 0.4% to 7,543.59, and the Nasdaq Composite rose 0.9% to 26,107.01. The U.S. dollar weakened across the board against major currencies, and the U.S. Dollar Index fell to around 100.7.

The crypto market’s reaction was even more direct. Bitcoin broke above $64,000 with trading volume support, topping out at about $65,000, and rose more than 4% on the day. Ethereum performed even more strongly, rising more than 6% to about $1,890. On-chain data showed that in the past 24 hours, nearly 70,000 traders were liquidated in the crypto market, with the liquidation amount reaching $345 million. Large-scale short positions were concentrated and closed out, and total liquidations across the entire network in 24 hours exceeded $370 million. Sygnum’s Chief Investment Officer said the latest inflation data implies that inflation pressure driven by rising energy prices this spring is gradually fading, which is positive for the crypto market.

From a macro perspective, the formation of lower rate-expectations is, in theory, favorable for capital to flow back into crypto assets such as Bitcoin and Ethereum. But how strong this transmission mechanism is depends on whether subsequent inflation data can continue to validate the easing logic.

Risk variables that cannot be ignored

Is the bond market’s repricing too optimistic? At least three risk factors deserve attention.

Risk one: the volatility of energy prices. The largest contribution to the June CPI cooling came from energy price declines, but this trend is facing challenges. As tensions between the United States and Iran continue to escalate, the Strait of Hormuz has once again become tense. As of July 15, Brent crude has rebounded to around $85 per barrel. If geopolitical risks further escalate and push oil prices above $90, even up to $100, energy inflation could rebound quickly, and at that time market expectations for Fed easing will face revision.

Risk two: the demand effect driven by AI investment. In his congressional testimony, Wosch specifically mentioned that the U.S. economy will “benefit from gains from AI investment that are difficult to estimate.” Continued growth in demand for AI chips at TSMC, tight HBM supply, and expanded semiconductor investment could continue to push up demand and prices in related areas. If AI capital expenditures form a sustained demand-pull effect, “AI inflation” could become a new source of price pressure.

Risk three: uncertainty in the Fed’s policy framework. Wosch emphasized in the hearing that the Fed needs to make “material adjustments” to policy. He set up five working groups to conduct a comprehensive review of how the Fed operates. This kind of institutional-level uncertainty means the Fed’s future policy reaction function may change—which is exactly the factor the market finds most difficult to price.

A comment from Tiffany Wilding, an economist at Pacific Investment Management Company, is representative: the latest inflation data “at least provides more room for the Fed to continue observing.” But this does not mean the door to rate hikes is already closed.

Conclusion

The 2-year U.S. Treasury yield’s largest single-day drop since August is a direct response by the bond market to the June CPI data, and it also reflects the market’s concentrated repricing of the Fed’s policy path. The sharp drop in short-end yields shows that the market is lowering expectations for near-term rate hikes and beginning to trade the possibility of a policy shift.

However, this does not mean the Fed has already determined it is entering a rate-cut cycle. Wosch’s hawkish remarks at the congressional hearing remind the market that an improvement in inflation data for a single month is not enough to change the Fed’s vigilance toward inflation. In the coming months, the persistence of inflation data, the direction of the labor market, and the evolution of energy prices will jointly determine whether the bond market’s assessment is correct.

For crypto assets, changes in rate expectations provide favorable macro conditions, but the sustainability of this logic still needs to be validated. Until the Fed’s policy path becomes clearer, market pricing for risk assets will continue to swing between “easing expectations” and “inflation re-accelerations.”

FAQ

Q: What does the sharp drop in the 2-year U.S. Treasury yield mean for the crypto market?

The 2-year U.S. Treasury yield reflects the market’s expectations for the Federal Reserve’s short-term interest rates. A decline in yields usually means the market thinks rate-hike pressure is easing, or even that it could turn toward easing—which helps improve the dollar liquidity environment, increase risk appetite, and theoretically provides macro support for crypto assets such as Bitcoin. But the strength of this transmission chain depends on whether subsequent economic data can continue to validate easing expectations.

Q: Will the Fed raise rates in July?

Based on the CME FedWatch tool after the CPI data release, the probability of a July rate hike has fallen sharply from about 50% before the data release to 15.5%, and the probability of keeping rates unchanged is 84.5%. The market broadly expects the Fed to keep the target range for the federal funds rate unchanged at 3.50% to 3.75% at its July 29 meeting.

Q: What exactly was the June CPI figure?

U.S. June CPI fell 0.4% month over month, the first time it turned negative since May 2020; it rose 3.5% year over year, below May’s 4.2%. Core CPI was flat month over month and rose 2.6% year over year. Both figures came in below market expectations.

Q: What does the yield curve becoming steeper imply for the economic outlook?

The spread between the 2-year and 10-year U.S. Treasuries widened (curve steepening), which usually means the market expects short-end rates to fall (rate-hike expectations fade) while long-end rates remain relatively stable. This shape may point to a “soft landing” scenario—inflation cools but the economy does not fall into recession, giving the Fed room to cut rates. But it could also indicate that concerns about long-term inflation and fiscal deficits are still persisting.

Q: How does the Middle East situation affect the Fed’s policy path?

The Middle East situation mainly affects inflation expectations through the energy price channel. The Strait of Hormuz is a crucial global oil transport route; if tensions remain high, oil prices could rise, which would then push up overall inflation. If energy prices continue to climb, it may force the Fed to maintain a tightening stance or even reconsider rate hikes—directly conflicting with the current market’s easing expectations formed based on CPI data.