The U.S. Treasury yield curve flattened last week following a sharp rally in Treasury yields, while U.S. equity indices were noted as becoming very overbought.

U.S. equities closed higher last week, extending a substantial rally, even as the Treasury yield curve continued to flatten, reflecting divergent signals within financial markets. This flattening occurred after a sharp rally in Treasury yields over the preceding three weeks, coinciding with U.S. equity indices showing increasingly overbought conditions.

The Event in Detail

Over the past month, Treasury yields experienced a significant rally, particularly in the three weeks leading up to last week. Despite this broader rally, the U.S. Treasury yield curve flattened, a movement characterized by the 2-year yield rising by 5 basis points (bps) while the 10-year yield declined by 1 bp and the 30-year yield fell by 8 bps. This differential performance suggests a market expectation of short-term rate adjustments coupled with more stable or declining long-term rates.

Concurrently, U.S. equity indices have demonstrated a relentless ascent, leading to widespread concerns about them entering an "overbought" phase. The Nasdaq Composite, in particular, has traded at overbought levels for nearly four months, indicating an extended period of upward momentum that has pushed valuations beyond typical ranges. The Federal Reserve's monetary policy, including an expected 25-basis-point rate cut, played a role in stabilizing yields, even as inflation data came in hotter than anticipated alongside signs of labor market weakness. The Federal Open Market Committee (FOMC) indeed approved a 25-basis-point rate cut on September 17, 2025, a decision described by Chair Powell as a 'risk management cut'.

Analysis of Market Reaction

The market's reaction reflects a complex interplay of forces. The flattening yield curve is often interpreted as a signal of increasing concerns about future economic growth or even a potential recession. This sentiment is partly driven by expectations that the Federal Reserve will continue its easing cycle. Money markets, for instance, were anticipating a 25-bp cut with around a 90% probability for September, aligning with the actual FOMC decision. The differential movement in short-term versus long-term yields implies that, while the Fed may cut rates, underlying fiscal pressures could keep long-term yields elevated.

Conversely, the robust performance of U.S. equity indices, despite these economic signals, points to strong investor confidence in prospective Federal Reserve interest-rate cuts and robust corporate earnings. This sustained rally, however, has led some analysts to describe the market as entering a "melt-up" phase, where rapid gains are driven by speculative behavior rather than fundamental strength. The mixed economic data, including hotter-than-expected inflation and signs of labor market weakness, further complicates this narrative, creating an environment where investors are weighing optimistic rate-cut expectations against underlying economic fragility.

Broader Context & Implications

The "overbought" status of U.S. equity indices is a significant point of discussion. As of September 13, 2025, the S&P 500 was trading approximately 10% above its 200-day moving average. The Nasdaq has shown even more extreme behavior, closing at overbought levels on just under 93% of trading days over a four-month period. Such a high frequency of overbought daily closes is rare, having only been exceeded in August 2020. This raises questions about the sustainability of the current rally.

The flattening yield curve has direct implications for various sectors. Banks, for example, typically thrive in a steep yield curve environment where they profit from the spread between short-term borrowing and long-term lending. A flatter curve compresses net interest margins, potentially creating headwinds for the banking sector. The S&P 500 Banks Index has reportedly underperformed equities since early 2025, with major institutions citing reduced loan demand amid economic uncertainty. This highlights a sector-specific vulnerability within the broader market.

Expert Commentary

Analysts have voiced cautious sentiments regarding the current market trajectory.

Satya Pradhuman, director of research at Cirrus Research, asserts that a melt-up is already in progress, stating, "The melt-up of risk-taking in U.S. equities has pierced the upper boundaries of a normalized range." He further describes the environment as "a very crowded equity market, combined with an extreme risk appetite," placing the U.S. equity market into an "overtly speculative chapter." Consequently, Cirrus Research's asset-allocation model has recommended an underweight to equities for the first time in three years.

Adam Turnquist, LPL Financial's chief technical strategist, suggests that investors should "maintain equity exposure equal to their benchmark and be prepared to increase it if a pullback, likely in the range of a 5% to 10% retreat, occurs."

Regarding the Fed's actions, Jack McIntyre, Portfolio Manager at Brandywine Global Investment Management, noted that the Fed is in a tough spot, expecting stagflation (higher inflation and a weaker labor market), which he described as "not a great environment for financial assets." He advised investors to diversify portfolios across geographies, currencies, and sectors. Brij Khurana, Fixed Income Portfolio Manager at Wellington Management, highlighted that while the market interpreted the additional two cuts in 2025 as dovish, the overall messaging might be hawkish, with the Fed acknowledging sticky inflation and putting more emphasis on the softening labor market.

Looking Ahead

The trajectory of Federal Reserve policy will remain a critical factor. While a 25-basis-point rate cut was implemented, the market's expectation of four to five rate cuts over the next 12 months, compared to the Fed's "dot plot" projection of 75 basis points in cuts for 2025, indicates potential for mispricing or future adjustments based on incoming economic data. The susceptibility of the market to a pullback if the Fed does not affirm a series of subsequent cuts is a key risk. Investors will closely monitor upcoming economic reports, particularly those related to inflation and labor markets, for further indications of the Fed's stance. The ongoing flattening of the yield curve also necessitates continued vigilance, as it may signal further economic deceleration, potentially impacting corporate earnings and market sentiment in the medium term.