Source: Zhitong Finance
Bond traders are increasingly convinced that US Treasury yields will fall as they bet on a series of interest rate cuts from the Federal Reserve, but the path to lower borrowing costs is bound to be extremely bumpy.
After experiencing some sharp fluctuations last year, the price of US Treasury bonds rebounded at the end of 2023, as investors caught signs that inflation was cooling, and Federal Reserve officials opened the door to speculation on interest rate cuts. Despite significant market fluctuations at the beginning of the year, traders are more convinced that the US will soon introduce large-scale monetary easing.
The latest employment and inflation data released on Friday — the producer price index fell unexpectedly — made the market think there is an 80% chance that the Federal Reserve will start cutting interest rates in March and push the benchmark US two-year Treasury yield to its lowest level since May. Despite this, Federal Reserve officials are still advocating a more gradual pace of interest rate cuts this year.
There is likely to be some fluctuation until this impasse is resolved in some way. The uncertainty behind this tense relationship is also evident in broad predictions of long-term yields, laying the foundation for some big winners and big losers. The data and the Federal Reserve spokesperson's schedule are unlikely to provide any decisive information in the upcoming shortened week of holidays.
Robert Tipp, chief investment strategist at PGIM Fixed Income, said the Federal Reserve will “wait a long time to ensure they have” evidence of deflation. “The evidence and data are elastic. Therefore, relative neutrality makes sense because it will be an environment for a trading range.”
Tipp said that the yield on 10-year US Treasury bonds will remain around 4%, but the yield for different terms will fluctuate, providing investors with trading opportunities. The yield on 2-year to 30-year treasury bonds is within 4% of 30 basis points, which makes most investors happy to snap up these securities when prices fall to obtain the attractive fixed payment stream provided by these securities.
There is still uncertainty about how the easing policy will work in the long run, especially considering the current supply of US debt, geopolitical tension, and upcoming elections.
Torsten Slok, chief economist at Apollo Management, pointed out in a report last week that these unknowns caused significant differences among long-term interest rate forecasters, paving the way for a “busy year” for the market.
Financial markets will be closed on Monday due to Martin Luther King's holiday, and economic data is in second place. This has caused the bond market to face more volatility. Meanwhile, surprising signals from some Federal Reserve officials suggest that the Federal Reserve may soon need to use quantitative austerity to control the amount of debt it allows to roll off its balance sheet, adding new uncertainty to monetary policy.
US Treasury futures positions have become more complicated. Currently, there are no extreme levels of bulls or bears in the market because traders are trying to determine the next big move. The market has begun to pay attention to the inflation data scheduled to be released when the Federal Reserve holds its next meeting at the end of January. The personal consumer spending price index (CPI), an inflation indicator favored by the Federal Reserve, will be announced on January 26.
Stephen Bartolini, fixed income portfolio manager at T. Rowe Price, said the Federal Reserve “has told us that they have reached the end of raising interest rates, and they have shown a tendency to cut interest rates.” “So they'll pay attention to personal spending because personal spending is closer to their predictions, or even more than their predictions, then they can increase the timing and speed of interest rate cuts.”
Throughout 2024, swap traders expect to cut interest rates by 25 basis points at least six times, which is more than double the amount of interest rate cuts suggested by Federal Reserve officials in the last round of quarterly forecasts in December last year. Since then, signs of labor market tension and easing inflation have prompted traders to continue to bet on aggressive easing policies this year — although the exact extent of overall interest rate cuts declined before and after the release of key data.
Macro strategist Simon White said, “The interest rate cut expectations for March have not changed much. This response seems to be consistent with a theory I put forward this week — liquidity, or reserves, has in fact become the Federal Reserve's main response function.”
The US Treasury will bid on new 10-year inflation-protected bonds on Thursday, which may reveal investors' attitudes. Barclays strategists said in a report that the yield of these bonds is about 1.75%, and although it is about 75 basis points lower than last year's peak, “it is still high, higher than most neutral real interest rate expectations.”
The difference between the yield on 10-year inflation-protected bonds and the yield on 10-year US Treasury bonds is 2.25 percentage points, which represents the average CPI inflation rate required to balance the benefits of the two over a period of time. Considering the difference between the CPI inflation rate and individual inflation indicators, the Fed's target is an average of around 2%, which is a vote of confidence in the Fed's policy.
editor/tolk