By Gertrude Chavez-Dreyfuss
NEW YORK, Oct 27 (Reuters) - Wall Street considers it settled that the Federal Reserve will hold interest rates steady this week. Whether that spells good news for Treasuries is more complicated.
After a bruising selloff that took yields up sharply for two months starting in August, the Treasury market has rallied, reflecting concern that financing troubles in a corner of the market for AI infrastructure could slow the artificial intelligence buildout that is a central driver
of the US economy. Yields have come down from the highs they hit early in October.
But analysts and portfolio managers stress that many of the forces that have made bond investors miserable this year — stubborn inflation, heavy government and corporate borrowing, and uncertainty over next week's midterm elections — remain in place. That makes it difficult to forecast what the rest of 2026 holds for a market where prices are still down significantly for the year.
"I don't think the Fed is entirely in the driver's seat in today's market. Increasingly, the bigger story is the AI-driven investment cycle and what happens to risk sentiment around it," said Christian Hoffmann, head of fixed income at Thornburg Investment Management.
"In recent trading, capital has moved out of some AI-related trades and into bonds in what looks like a flight to quality, and flows like that can overwhelm relatively small changes in Fed expectations."
FEW EXPECT A RATE INCREASE
Investors expect the Fed to stay on hold but to raise rates again in December. The decision may be less important than what officials signal about inflation and the path of rates in the months ahead, investors said. Markets have repeatedly swung between expectations for policy easing and tightening on concerns that persistent price pressures could force the Fed to keep borrowing costs elevated for longer.
The benchmark 10-year yield has risen 84 basis points this year, on track for its largest yearly increase since 2022. US 30-year yields are up nearly 50 basis points in 2026, their biggest yearly rise since 2024.
Of late, comments from Fed officials John Williams and Philip Jefferson helped to reset investor expectations towards fewer near-term rate hikes. Both sit on the policy-making Federal Open Market Committee. But few have forgotten that consumer and producer prices rose in August and September, with higher energy prices -- which remain elevated -- as one of the main culprits.
"Inflation has clearly re-accelerated so to us this isn't necessarily a pause, but just to see how some of this data changes given the recent hike," said Jack Herr, senior investment analyst at GuideStone Funds. "The Fed will probably hike again this year."
FISCAL HEADWINDS
Even if the Fed stays on hold, the long end of the curve -- bonds with maturities of 10 or more years -- could remain under pressure. JPMorgan's latest Treasury Client Survey showed client positioning with the fewest outright longs since mid-August, reflecting reduced betting on lower yields.
That outlook reflects in part the government's growing financing need, with a worsening fiscal backdrop and the $40 trillion national debt contributing to bouts of volatility.
Treasury issuance has surged alongside widening budget deficits, increasing the amount of debt that private investors must absorb. The steady increase in supply has become an important driver of longer-term yields and has at times overshadowed changes in Fed policy expectations.
"It's hard to have a lot of confidence in exactly what's going to happen from here, especially when you're looking at ongoing deficits on the order of 6% of GDP (gross domestic product)," said Chris Maxey, chief market strategist at Wealthspire Advisors.
"Our net debt interest costs could actually consume more of our deficit, and that begins to squeeze out other spending that happens. That could naturally push yields higher across the curve because there's just that fiscal concern element."
Many investors took the intensity of the late summer bond rout as a shot across the bow of policy makers, but even those who believe the message was received say it will take time to change the momentum on spending in Washington.
"Regardless of the election results, we should not probably expect any meaningful fiscal restraint," said Oli Shale, US investment specialist at asset manager Ruffer. "More spending is the path of least resistance and this regime is not going anywhere for some time."
(Reporting by Gertrude Chavez-Dreyfuss, editing by Colin Barr)
