In the first half of this year, US Treasury investors' expectations for higher interest rates were consistent with the signals sent by the Federal Reserve for a longer period of time. Now, as investors weigh the timing of an interest rate cut in the second half of the year, they face another uncertain risk --- the fiercely competitive US presidential election.

Due to two consecutive months of increase, the US bond market has approached a break-even point, with the benchmark bond index falling by only 0.15% in the first half of 2024. Since 2021, US Treasury yields have failed to achieve two consecutive months of gains. If the current upward trend in US bonds is to continue, data showing a slowdown in the US economy and softening inflation will need to be sustained as this will increase the possibility of the Federal Reserve cutting rates as early as September.

Investors who were preparing for six interest rate cuts earlier this year now even believe that the Federal Reserve will not cut rates if necessary. However, traders widely expect at least one 25 basis point rate cut before the end of the year and it's very likely that there will be two cuts. This will always be a major event, potentially allowing the US bond market to return to normal after experiencing a record two-year/10-year bond yield inversion. Currently, the yield on 10-year US Treasuries is around 4.25%, about half a percentage point lower than the yield on the two-year note.

For many investors, even as the election approaches, economic data and Federal Reserve policy are still the focus. However, even so, fiscal factors could also have a significant impact on the market.

US election brings risks to US bonds: US government debt will rise.

Investors will also face the US presidential election, which could potentially influence the interest rate cycle. The first debate between Biden and Trump is scheduled for Thursday. With increased risks and unknown factors surrounding the campaign, it could further trigger the yield curve to shake, allowing investors betting on the return to a normal interest rate structure to reap rewards. This bet has not paid off yet given the Federal Reserve's inaction.

Gargi Chaudhuri, head of investment strategy for iShares in America at BlackRock, said:"Of course, we can see some volatility in the market as we head into the election."

Obviously, neither Biden nor Trump seems willing to curb high deficit spending, so the continually rising US debt burden under any government is likely to lead investors to demand a higher premium to hold longer-term US Treasury bonds. The focus on Thursday and beyond will also be on whether Trump expresses a desire to adjust the Federal Reserve's independence, or how much both candidates misspeak.

Chaudhuri said: "many people are worried that issues such as an increase in the deficit, a rise in the proportion of debt to GDP, and so on, will not disappear regardless of the result of the presidential election."

This year, election risks abound around the world. The results of Mexico's elections in June were thought to open the door to comprehensive constitutional reforms, which have already had an impact on the market. France is about to hold parliamentary elections, and President Macron's hasty decision has caused market pains as government debt is expected to skyrocket.

Vanguard portfolio manager John Madziyire said:"Think of the French election or the French statement. No one knows what the outcome will be, but what you know is that given this uncertainty, you need to start reducing your holdings of French bonds."

As the election approaches, it remains to be seen whether US Treasuries will receive similar treatment --- although the US is currently supported by its global safe-haven status. It is obvious that investors are widely cautious about the increasing $2 trillion fiscal deficit under either president candidate and mounting debt burdens, through either increased spending and decreased tax or some combination. These topics may arise on Thursday.

The current outstanding US debt is more than six times the size of the US bond market in mid-2007. The nonpartisan Congressional Budget Office projects that long-term deficits will cause US debt to increase to about $50 trillion by the end of 2034.

Debt risk is not priced.

As the US Treasury sells more long-term bonds to fund its deficits, this supply will put upward pressure on yields. But beyond that, what worries some investors more is that current long-term yields do not fully reflect the growing risks in finance and related fields.

The Federal Reserve model currently has a negative value for the so-called term premium on 10-year US Treasury notes. The term premium is approximately the additional yield required by investors to hold longer-term bonds rather than shorter-term securities to compensate for the extension risk. This ratio is about -0.27%, well below the peak of 0.46% set in October last year, when concerns about the US fiscal situation were very high.

The risk is that as the US election rekindles attention on the deficit and debt, the premium will turn positive and expand - this was mentioned in a report by Goldman Sachs this week. Market observers say that if the same party controls the White House and Congress, the risk will be amplified, as it will increase the chances of legislation for increasing the deficit.

Columbia Threadneedle Investment's interest rate strategist, Ed Al-Hussainy, said:"It doesn't matter if it's the Democratic Party or the Republican Party, but one-party rule means a worsening of the deficit, so you should be confident in shorting long-term treasuries." He believes that "there may be more than 50 basis points of term premium upside."

If Trump is elected, the independence of the Federal Reserve is in doubt, and the risk premium may rise.

One area where there does seem to be a difference between the two candidates is the independence of the Federal Reserve, with reports suggesting that some of Trump's informal advisers have proposed ideas for reform that would give him greater control over the Fed, making the topic an election issue.

In a recent institutional survey, 44% of respondents said they expected Trump, if back in the White House, to seek to politicize the Fed or limit its powers. However, the reality is that the newly elected Trump's ability to make significant changes to the Fed beyond appointment of officials may be limited. But for some investors, the mere thought of the central bank losing its independence means that the risk premium should be higher.

Marion Le Morhedec, Global Head of Fixed Income at Allianz Investment Management, said:"After so many seemingly unimaginable events in recent years, investors have understood that we can never say never now."

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