Source: Wall Street See
Author: Zhang Yaqi.

Is USA bonds the biggest loser of the rate cut by the Federal Reserve?

The unexpected 50 basis points rate cut by the Federal Reserve last week led to a jubilant atmosphere in the US stock market. However, Bloomberg macro strategist Simon White believes that this rate cut decision may lead to greater price and liquidity risks in the US government bond market, making it the biggest loser.

Nobel laureate in Economics, Milton Friedman, once vividly used the metaphor of 'fool in the shower' to describe the potential lag in central banks' monetary policy formulation. He believed that adjustments in central bank policies often lag behind the actual economic conditions due to excessive optimism, resulting in policy effects falling short of expectations.

This rate cut by the Federal Reserve may indeed confirm Friedman's point of view. In a situation where the economic outlook remains uncertain, a rapid rate cut may exacerbate the term premium of long bonds, leading to greater liquidity risks in the US government bond market.

Rate cuts lead to a bearish trend in the ​bonds market.

White believes that inflation and its volatility are the two biggest risks faced by long-term bonds.

After a rate cut by the Federal Reserve, inflation volatility often increases significantly more than when rates are raised or remain unchanged.

Typically, after the Federal Reserve eases its policies, the yield curve steepens, indicating positive economic prospects. However, White believes that in the current cycle, due to liquidity and inflation risks, long-term bond yields rise, leading to a steepening of the yield curve which might become the new norm.

White points out that based on historical data, a rate cut usually leads to an increase in the term premium of long-term treasuries. Term premium reflects the additional yield investors require for holding long-term bonds to compensate for the uncertainty of inflation and its trends.

Moreover, the extent of the rate cut is significantly positively correlated with the term premium and the steepness of the yield curve, the greater the extent of the surprise, the steeper the yield curve. Last week's rate cut decision is seen as the largest downside surprise in the past two decades beyond crisis and bear market conditions. This uncertainty has made the market more cautious about future economic trends.

Although the Federal Reserve has set the expectation for a 50 basis point rate cut, the current economic conditions do not show signs of a recession. This implies that such a large rate cut may not be necessary. White states that this suggests a higher possibility of an unexpected rate hike (Fed's rate cut lower than market expectations), leading to an increase in the term premium and pushing long-term yields higher.

"All these factors together create the perfect storm for long-term yields: increased uncertainty, lower rates, and the negative impact on risk assets due to rates exceeding expectations."

Intensified liquidity, worsening fiscal deficits, increased inflation risks... The outlook for US bonds becomes even more grim.

Currently, the liquidity of the USA treasury bond market is facing severe challenges. The Bloomberg Treasury Bond Liquidity Index recently hit a new high, indicating poor liquidity in the USA treasury bond market. Although the index has fallen from its peak, it still remains at a high level for most of the past 15 years.

"In any case, the Federal Reserve's loose policy leading to increased inflation volatility will inevitably cause liquidity risks to rise again."

Furthermore, with the federal government's fiscal deficit reaching as high as 1.5 to 2 trillion US dollars, the inflation risk has significantly increased, making the liquidity outlook for the bond market even more challenging.

White pointed out that over the past two years, the issuance of USA treasury bonds has sharply increased to meet the expanding borrowing demand, but current issuance levels are stabilizing, leading to significantly longer bond maturities.

"In the scenario of extensive government borrowing and the Federal Reserve exacerbating inflation risks, the market may not be willing to continue purchasing long-term bonds at current prices."

Therefore, as the market demands a greater safety margin for holding government debt, term premiums may rise.

Editor/Jeffy