The bond market rally rides on how fast the Fed cuts rates

BOND traders who struggled to predict how high the US Federal Reserve would raise interest rates are finding the way down just as vexing.

At TCW Group, Jamie Patton, the co-head of global rates, is convinced that even the swift easing that is now baked into financial markets does not go far enough. This leaves shorter-dated US Treasuries plenty of room to keep rallying. “The Fed is going to have to lower rates faster and more aggressively than what the market’s priced in,” she said. 

At JPMorgan Asset Management, Bob Michele sees it differently. He is betting that the bond market has already run too far ahead of the Federal Reserve as the economy keeps chugging along – albeit at a slower pace.

As a result, he is favouring corporate bonds, which carry higher payouts, over Treasuries. “I don’t see anything breaking,” he said.

The divergent views are at the heart of what is at stake for investors as the US central bank is virtually certain to start cutting interest rates for the first time since 2020 at its Sep 18 meeting.

That prospect alone has already sent bond prices surging sharply as traders seek to get ahead of the moves, creating the risk that markets will again be upended by a post-pandemic economy that has consistently surprised the Fed and Wall Street forecasters with its resilience.

On Monday (Sep 9), Treasuries slipped, with yields rising as much as five basis points, after the US Labor Department’s employment report last week underscored the uncertain outlook.

Employers expanded payrolls at a slower-than-expected pace of 142,000 in August, capping the weakest three months of job growth since mid-2020.

However, the slowdown was not sharp enough to tip the debate over how swiftly – or how deeply – the Fed is likely to ease policy in the months ahead.

Traders are still putting the highest odds on the Fed reducing its target rate – now in a range of 5.25 to 5.5 per cent – by a quarter-percentage-point this month, though those at Citigroup and some other banks are betting on a half-point move.

By mid-2025, swaps markets are pricing in that it will be cut to about 3 per cent, roughly around the level that is seen as neutral to economic growth.

But the Fed’s trajectory has repeatedly blindsided traders since the pandemic. Anticipating that the inflation surge would be brief, they underestimated how high rates would go.

Then they prematurely piled into bets that it was poised to reverse course, leaving them hit by new rounds of losses when it did not. 

That has sown some doubts about whether bond prices have again run up too far. The two-year Treasury yield, which closely tracks the Fed’s key policy rate, has tumbled to about 3.7 per cent from more than 5 per cent in late April – enough to account for five quarter-point Fed moves.

The cheaper borrowing costs have also filtered through to corporate bonds and stock prices, easing financial conditions without any action from the US central bank. 

“The Fed needs to cut, we all know that, but the question is the pace,” said John Madziyire, senior portfolio manager at Vanguard, which manages US$9.7 trillion in assets. He said his company has adopted a “tactical short bias” towards the bond market since the recent rally. 

“If the Fed became aggressive and started doing 50-basis-point cuts,” he said, “making financial conditions even more loose, then we have risk that we get some re-acceleration of inflation.”

So far, though, inflation has been heading in the right direction: On Wednesday, the US Labor Department is expected to report that the consumer price index rose 2.6 per cent in August from a year earlier, indicated the median forecast of economists surveyed by Bloomberg.

That would be the smallest increase since 2021. There will be little new guidance from Fed officials, who are in the traditional blackout period ahead of the Sep 17 to 18 meeting.

The bank’s trajectory will depend on whether the Fed pulls the economy into a soft landing or is forced to shift into recession-fighting mode, as it did during the Wall Street credit crisis or after the Internet bubble’s collapse.

Right now, economists are largely predicting that the economy will avoid a contraction, leaving stocks holding not far from record highs despite the recent slump.

JPMorgan’s Michele, the chief investment officer for global fixed income, is anticipating that the Fed will wind up only needing to cut its benchmark by 75 to 125 basis points, a parallel to what happened in the mid-1990s.

Back then, the economy continued expanding even after the US central bank doubled interest rates to 6 per cent, which were only nudged down slightly.

“There’s only been one soft landing that we can all agree on and that was 1995,” he said. “I see a lot of similarities with this time.”

Nuveen’s chief investment officer Saira Malik also has doubts about how far the market has run ahead of the Fed. That has driven Treasuries to gains over the past four months, marking the longest winning streak since 2021, before the onset of the Fed’s rate hikes. 

But she thinks the market is poised for some disappointment. “The Fed will go slower rather than faster because the economy is not on the cusp of a recession,” she said.

She predicts the 10-year yield could rise back towards 4 per cent from around 3.7 per cent now. “Treasuries have moved a little bit too far, too fast.” BLOOMBERG