There is clear evidence that the US labor market is cooling down, and the Federal Reserve's interest rate cut in September is almost certain, although the extent and speed of interest rate cuts are still disputed.

For bond traders, the extent and speed of interest rate cuts is a headache. Traders who have misjudged the pace of the Fed's interest rate hikes have found that predicting interest rate cuts is just as annoying.

Currently, there are serious differences in market opinions. On the one hand, they believe that interest rate cut transactions have already been carried out ahead of schedule, and that the sharp decline in US bond interest rates has already been priced and absorbed by the Federal Reserve's future interest rate cuts; on the other hand, they believe that the Fed's interest rate cut may be more aggressive and exceed market expectations, and that there is still room for US debt to rise. However, the consensus is that the future trend of US debt may depend on the pace at which the Federal Reserve cuts interest rates.

US debt rushing away? The future trend of US debt may depend on the pace of the Fed's interest rate cut

As the Federal Reserve meeting on September 18 approaches, the market generally expects the Fed to cut interest rates for the first time since 2020. This expectation has previously driven a sharp rise in US debt.

Currently, policy-sensitive$U.S. 2-Year Treasury Notes Yield (US2Y.BD)$It has dropped all the way from over 5% in April to around 3.7%.$U.S. 10-Year Treasury Notes Yield (US10Y.BD)$It has also reached a level of 3.7% from 4.5% in April. The sharp rise in US debt already reflects the market's pricing for future Federal Reserve interest rate cuts. Lower borrowing costs have also contributed to the rise in corporate bonds and stocks, relieving pressure on financial markets.

Some investors believe that US bonds have taken a big break from the market.

John Madziyire, senior investment manager at Vanguard, which manages 9.7 trillion dollar assets, said that everyone knows that the Federal Reserve needs to cut interest rates, but the key is speed. If interest rates are cut too fast, it may cause inflation to accelerate again. He believes that the current bond market is rising too fast and has adopted a “tactical short-term bearish” stance.

Nuveen's chief investment officer Saira Malik also said that the market may be too optimistic about the speed at which the Federal Reserve will cut interest rates, believing that the 10-year Treasury yield may rise from the current 3.7% to around 4%. Bob Michele of J.P. Morgan Asset Management also believes that the bond market is ahead of the Federal Reserve's actions. Although the economy is slowing down, it has not deteriorated. He prefers to invest in corporate bonds with high returns rather than treasury bonds.

TCW Group's Jamie Patton, however, held the exact opposite view. Patton believes that market expectations are insufficient, and that short-term US Treasury bonds may still have room to rise. She said, “The Federal Reserve will have to lower interest rates faster and more aggressively than market expectations.”

BlackRock's senior portfolio manager Jeffrey Rosenberg also issued a warning that the Federal Reserve's interest rate cut may exceed expectations. He said that if interest rates are cut by 50 basis points in September, it may indicate concerns (about the economy), which may cause severe market turmoil.

The Bloomberg article reports that although the market's expectations for the Fed to cut interest rates are high, market judgments have been punched in the face many times. Traders have underestimated the extent of the Fed's interest rate hike, then bet too early that the Fed will reverse its policy, and as a result, they have suffered new losses. Economic performance after the pandemic has surpassed expectations, and the predictions of the Federal Reserve and Wall Street have repeatedly failed.

There are still risks in the US bond market, but many analysts agree that the trend of US bonds is related to the speed and extent of the Federal Reserve's subsequent interest rate cuts.

What is the pace of the Federal Reserve cutting interest rates?

Regarding the extent of the interest rate cut in September, Goldman Sachs commented on the Federal Reserve official's speech in the research report, saying that the Federal Reserve leadership believes that the September interest rate cut of 25 basis points is the benchmark situation.

In our opinion, these remarks are consistent with our statement that the Federal Reserve cut interest rates by 25 basis points in September, but if the labor market continues to deteriorate, the Fed leadership is willing to cut interest rates by 50 basis points at subsequent meetings.

According to the Wall Street Journal, Peter Cardillo, chief market economist at Spartan Capital Securities, said, “The fact that more than 0.1 million new non-farm payrolls were added (August) weakens the possibility that the Federal Reserve will cut interest rates (50 basis points) at the September meeting. However, data revisions from previous months indicate that the Federal Reserve will need to cut interest rates by at least 75 basis points this year.” Since the Federal Reserve has three more meetings to be held this year, it is only necessary to cut interest rates by 25 basis points for each meeting to achieve this goal.

Regarding the pace of interest rate cuts throughout the year, CME's data shows that although investors think it is more likely that the Fed will cut interest rates by 25 basis points in September, they actually bet that the Fed will cut interest rates by 100 basis points or more by the end of the year.

Shenwan Hongyuan Securities, on the other hand, believes that the pace at which the Federal Reserve will cut interest rates during the year is: 25bp+25bp+25bps. It points out that the pace at which the Federal Reserve cuts interest rates depends on economic fundamentals. The way the economy “lands” determines the downward slope and space for interest rates on US bonds. In a recession, the Federal Reserve cut interest rates even more. And the trend of inflation is the main contradiction in the Federal Reserve's policy stance. If the forces driving the rebound in inflation are temporary, then interest rate cut deals are more likely to be repeated rather than reversed.

edit/ping