Weak job creation and elevated inflation make a strange pair

After a potentially bumpy December, US Treasury (UST) market yields seem likely to remain constrained in a narrow range to start the new year as the US economy continues to expand. Consumer spending, supported by higher income households and corporate capital expenditures linked to the AI build-out, continue to provide a solid foundation for US growth. Although the markets face incomplete and delayed federal data releases in the wake of the 43-day government shutdown, private sector and alternative data sources continue to portray a resilient US economy. Inflation, meanwhile, remains elevated, closer to 3% than to the Fed’s 2% target.

The decline in Federal outlays and related multiplier effects likely will subtract 1-1.5 percentage points from Q4 GDP, but financial markets have moved on, expecting that most of that decline will be made up in early 2026. In addition, various tax breaks in the One Big Beautiful Bill Act should give a further short-term boost to GDP next year.

Meanwhile, despite the economy’s resilience, job creation has slowed and corporate layoff announcements have increased. The combination of tariffs, other cost pressures, and increased use of labor-saving technologies may be weighing on firms’ willingness to expand payrolls, a trend that may continue. So far, in response, the Federal Reserve has eased its target federal funds rate gradually towards a neutral level that theoretically should neither stimulate nor restrain the economy.

Recent market pricing of fed funds futures indicates near certainty of a 25 basis point cut at the upcoming December Fed meeting and more to follow, driving the fed funds rate to about 3.0% in early 2027. President Trump’s anticipated nomination of a “dovish” successor to Fed Chair Powell has exerted downward pressure on the expected level of policy rates. This has outweighed concerns expressed by some current Fed policy makers about elevated inflation. 

Beyond its upcoming December meeting, the Fed’s policy-making Federal Open Market Committee (FOMC) faces some big questions in 2026: (1) how will threats to both sides of the Fed’s dual mandate of inflation and maximum employment unfold?; (2) will the routine, five-year Fed Board of Governors reappointment of the sitting regional Fed bank presidents become contentious?; and (3) will Chair Powell stay on as a Fed Governor to deprive Trump of another appointment?  The answers to these questions could affect market perceptions of Fed independence in the year to come and thereafter.

Shifting back to the near-term market outlook, international market factors are likely to provide varying influences on UST yields. Upward pressure from the Bank of Japan signals that it may accelerate its tightening cycle, and counters downward pressure from the European Central Bank’s easing and moderate growth in China. Global oil markets remain well supplied, and weakening prices are offering some disinflationary impetus going forward.

UST yields have remained in a narrow range during the last six weeks, with a notable failure to sustain the UST 10-year yield below 4%. In fact, consensus expectations have settled around the 10-year yield staying around 4.0% through 2026. Assuming rate cuts continue as expected, the slope of the Treasury yield curve should continue to steepen. Lately, risk assets—including, for example, stocks and high yield corporate bonds—have become more volatile. Creeping doubts about the returns to heavy AI-related capex have provided temporary demand for Treasurys that has faded once investors emerge to buy risk assets on any material weakness—a pattern that may repeat in the near term.

With an array of countervailing forces driving the Treasury market, the US economy apt to reaccelerate following a weak current quarter, and significant Fed easing already priced into the market, the balance of risks to US Treasury yield direction has become symmetric. Given often less liquid and, at times, choppy December markets, the Federated Hermes Duration Committee currently favors a neutral duration positioning.