Bond traders are increasingly convinced that US yields will fall because they are betting that the Federal Reserve will cut interest rates in a series of rates, but the path to lower borrowing costs is bound to be extremely difficult.

After experiencing some sharp fluctuations last year, US Treasury bonds rebounded at the end of 2023 because US inflation was cooling down and the Federal Reserve opened the door to cutting interest rates. Despite significant market fluctuations at the beginning of the year, traders are more convinced that the Federal Reserve will soon introduce large-scale monetary easing.

The latest inflation data released earlier showed an unexpected drop in the producer price index (PPI), making the market think there is an 80% chance that the Fed 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.

The market is likely to experience some fluctuation until this impasse is resolved in some way.

Robert Tipp, chief investment strategist at PGIM Fixed Income, said that the Federal Reserve will “wait a long time to ensure they have sufficient evidence. The data is very elastic. Therefore, it makes sense for the Federal Reserve to remain relatively neutral.”

Tipp said that the yield on 10-year US Treasury bonds will remain around 4%, but the yield on US bonds with different maturities will fluctuate, providing investors with trading opportunities. The yield on 2-year to 30-year US bonds is within 4% of 30 basis points, which makes most investors happy to buy these bonds when prices fall.

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 the upcoming US presidential election.

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.

US Treasury futures positions have become more complicated. Currently, there are no extreme levels of bulls or bears in the market. The market has already begun to pay attention to the last key inflation data before the next meeting of the Federal Reserve. The PCE price index, the inflation index 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 be watching the PCE price index. If this data comes closer to their predictions, or even exceeds their predictions, then they can increase the timing and speed of interest rate cuts.”

Currently, swap traders expect the Fed to cut interest rates at least 6 times, by 25 basis points each time. This is more than double the rate cut suggested by Fed 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. Foreign media macro strategist Simon White said:

The market's expectations of the Fed's interest rate cut as early as March have not changed much. This reaction seems to be consistent with a theory I put forward this week. Liquidity, that is, reserves, has become the Fed's actual focus.

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 probably the market's “vote of confidence” in the Fed.

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