The bond market rally hinges on how quickly the Fed will taper

(Bloomberg) — Bond traders who struggled to predict how high the Federal Reserve would raise interest rates are finding the downward path just as vexing.

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At TCW Group Inc., Jamie Patton, co-head of global rates, is convinced that even the rapid easing now in place in financial markets does not go far enough, leaving shorter-dated Treasuries plenty of room to continue to align. “The Fed will have to cut rates faster and more aggressively than the market is pricing in,” she said.

At JPMorgan Asset Management, Bob Michele sees things differently. He’s betting that the bond market has already gotten too far ahead of the Fed because the economy is still going — albeit at a slower pace. As a result, he prefers corporate bonds — which generate higher payouts — over Treasuries. “I don’t see anything breaking,” he said.

The divergent views are at the heart of what’s 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 September 18 meeting. That prospect alone has already caused bond prices to spike as traders try to get ahead of the moves, raising the risk that markets could once again be upended by a post-pandemic economy that has consistently surprised Fed and Wall Street forecasters with its resistance.

On Friday, the Labor Department’s employment report 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. But the slowdown was not strong enough to tilting the debate over how quickly — or how deeply — the Fed is likely to ease policy in the coming months.

Traders are still the top oddsmakers for the Fed to cut its target rate — now in a range of 5.25 percent to 5.5 percent — by a quarter of a percentage point this month, although those at Citigroup Inc. and other banks are betting on a half-point move. By mid-2025, the swap markets are pricing in that it will be reduced to about 3%, roughly around the level that is considered neutral for economic growth.

But the Fed’s trajectory has repeatedly blindsided traders since the pandemic. Anticipating that the rise in inflation would be short, they underestimated how high rates would go. Then they made premature bets that he was ready to reverse course, leaving them hit with new rounds of losses when he didn’t.

The story continues

That has sown some doubts that bond prices have risen too much again. The two-year Treasury yield, which closely tracks the Fed’s key policy interest rate, fell to about 3.7 percent from more than 5 percent in late April — enough to explain the Fed’s five-quarter point moves. Cheaper borrowing costs also filtered down to corporate bonds and stock prices, easing financial conditions without any Fed action.

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

“If the Fed got aggressive and started to cut by 50 basis points,” he said, “making financial conditions even looser, then we run the risk of getting some reacceleration of inflation.”

So far, though, inflation has been headed in the right direction: On Wednesday, the Labor Department is expected to report that the consumer price index rose 2.6 percent in August from a year earlier, according to the average forecast of economists polled by Bloomberg . That would be the smallest increase since 2021. There will be little new guidance from Fed officials, who are in their traditional lock-in period ahead of their Sept. 17-18 meeting.

The bank’s trajectory will depend on whether the Fed drags the economy into a soft landing or is forced into recession-fighting mode, as it did during the Wall Street credit crunch or after the collapse of the dot-com bubble. Economists now largely predict the economy will avoid a contraction, leaving inventories not far from record highs despite the recent recession.

What Bloomberg strategists say:

“There is very little chance that the Federal Reserve will cut by 50 basis points on September 18, based on 4.2% unemployment. However, the two-year yield declined. So the bottom line is that the price for two-year Treasuries is very rich, and we’re likely to see them rise from here as the reality sinks in.”

—Ed Harrison, macro strategist

Read more here.

JPMorgan’s Michele, chief investment officer for global fixed income, predicts the Fed will only need to cut its benchmark by 75 to 125 basis points, noting a parallel to what happened in the mid-1990s. Back then, the economy continued to expand even after the central bank doubled interest rates to 6%, which were only slightly reduced.

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

At Nuveen, Saira Malik, its chief investment officer, also has doubts about how far the market has gone ahead of the Fed. That has led Treasuries to post gains over the past four months, marking the longest winning streak since 2021 before the start of Fed rate hikes.

But she believes the market is set for some disappointment. “The Fed will go slower than faster because the economy is not on the brink of recession,” she said, predicting that the 10-year yield could rise back to 4 percent from about 3.7 percent now. “Treasury moved a little too far, too fast.”

What to watch

• Economic data:

  • Sept. 9: Wholesale stocks; New York Fed 1-Year Inflation Expectations; consumer credit

  • September 10: NFIB Small Business Optimism

  • September 11: MBA mortgage applications; consumer price index; average real earnings

  • September 12: Producer Price Index; unemployment claims; change in household net worth; monthly budget statement

  • September 13: Import and Export Price Index; University of Michigan sentiment/current conditions/expectations

• Fed calendar:

• Auction calendar:

  • September 9: 13, 26 week bills

  • September 10: 42-day cash management invoices; 3 year grades

  • September 11: 17 weeks’ bills; Reopening of 10-year banknotes

  • September 12: 4, 8 week bills; Reopening 30-year bonds

–With assistance from Kristine Aquino and Ye Xie.

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