As the prospects for the Federal Reserve's path to cutting interest rates became more uncertain, bond investors began to take defensive measures. The higher-than-expected inflation data and weak labor market data released last week caused traders to cut their bets on how much the Federal Reserve would cut interest rates for the rest of 2024, while also pushing US bond yields to their highest level since July. Furthermore, a closely watched indicator measuring the expected volatility of US bonds also rose to its highest level since January.

In this context, it is difficult for investors to decide where to allocate their cash in the world's largest bond market. To mitigate vulnerability due to economic resilience, potential fiscal shocks, or US election turmoil, asset management companies, including giants such as BlackRock, Pacific Investment Management (PIMCO), and UBS Global Wealth Management, are advocating buying 5-year bonds because 5-year bonds are less sensitive to such risks than short-term or long-term bonds.

Solita Marcelli, the chief investment officer for the Americas at UBS Global Wealth Management, suggests investing in medium-term bonds, such as 5-year US bonds and investment-grade corporate bonds. “We continue to recommend investors prepare for a low interest rate environment and invest their excess cash, money market assets, and maturing time deposits in assets that provide more lasting income,” she said.

Bond traders are currently betting that the Federal Reserve will cut interest rates by a total of 45 basis points during the next two policy meetings, lower than the 50 basis points bet placed before the September non-farm payrolls report was released. At the same time, options trading is betting that interest rates will be cut again this year. A more complex options transaction is betting that interest rates will be cut by another 25 basis points this year and that interest rate cuts will be suspended early next year.

There is still plenty of room for market volatility in the next few weeks, and it's not just about the US election — the election will determine investors' expectations for US fiscal policy. The ICE BofA Move Index — a volatility indicator that tracks fluctuations in expected yield based on options — is just one step away from the 2024 high, indicating that investors don't expect the turmoil to abate.

Interest rate fluctuations are likely to continue for weeks as investors await the US Treasury's announcement of quarterly note and bond sales, next month's employment report, and the Federal Reserve's interest rate decision on November 7. Citadel Securities warns clients to prepare for “significant future fluctuations” in the bond market. The company expects the Federal Reserve to cut interest rates by another 25 basis points in 2024.

Investors expect the Federal Reserve will further ease interest rate restrictions in the coming months to ensure a soft landing for the economy. David Rogal, portfolio manager for BlackRock's basic fixed income division, said: “As the general election enters the option value window, implied volatility will increase.” The company favors medium-term US debt because it believes that as soon as inflation cools down, the Federal Reserve will implement a “readjustment cycle” to adjust the policy interest rate from 5% to between 3.5% and 4%.

Investors' concerns that America's rising deficit will cause trouble for long-term US debt will help establish the “dessert zone” status of five-year US bonds. Anmol Sinha, head of investment at Capital Group's 91.4 billion dollar bond fund, said: “The part of the yield curve with a shorter term, that is, five years or more, currently seems more attractive to us.” He added that their positions would benefit from “more obvious growth slowdown, economic recession, or negative shocks”. Another situation is that against the backdrop of low risk premiums on long-term bonds, people are worried about rising fiscal deficits and the impending supply of treasury bonds.

Despite this, in $U.S. 10-Year Treasury Notes Yield (US10Y.BD)$ Close to 4.1%, the sell-off that occurred after the employment data was released also pushed 10-year US bonds into a “buying zone” for some long-term investors. Roger Hallam, head of global interest rates at Vanguard, said: “Our core view is that the economy will indeed slow down next year because the Federal Reserve's policies will remain restrictive. This means that when the 10-year US Treasury yield is above 4%, there is an opportunity to begin extending the term of our portfolio while considering the downward growth impulse next year.” He added that this will allow the company to slowly shift to more increased debt holdings.

According to reports, since about the beginning of September, Vanguard has also benefited from tactical short bets on US bonds when US bond yields began to rise. The company is still conducting this short-term deal, but the scale has been reduced from its initial level.

Edit/Rocky