(Bloomberg) — Bond traders who struggled to predict how much the Federal Reserve would raise interest rates are finding the path down just as annoying.
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At TCW Group Inc. Jamie Patton, co-head of global rates, is convinced that even the rapid easing now baked into financial markets does not go far enough, leaving short-term government bonds plenty of room to continue rising. “The Fed will have to cut rates faster and more aggressively than what the market has priced in,” she said.
At JPMorgan Asset Management, Bob Michele sees it differently. He’s betting that the bond market has already gotten too far ahead of the Fed, while the economy continues to move along — albeit at a slower pace. As a result, he prefers corporate bonds – which offer higher payouts – over government bonds. “I don’t see anything breaking,” he said.
The divergent views are at the heart of what’s at stake for investors as the U.S. central bank will almost certainly start cutting rates for the first time since 2020 at its September 18 meeting. That prospect alone has caused bond prices to rise sharply as traders try to get ahead of the curve. This raises the risk that markets will once again be upended by a post-pandemic economy that continues to surprise Fed and Wall Street forecasters with its resilience.
On Friday, the Labor Department’s employment report underscored the uncertain outlook. Employers expanded payrolls at a slower-than-expected pace of 142,000 in August, surpassing the weakest three months of job growth since mid-2020. But the slowdown wasn’t sharp enough to tilt the debate over how quickly — or how deeply — the Fed is likely to ease policy in coming months.
Traders still have high hopes that the Fed will cut its target interest rate – now in a range of 5.25% to 5.5% – by a quarter of a percentage point this month, although Citigroup Inc.’s and some other banks are betting on an interest rate cut. half point movement. By mid-2025, swap markets price this rate to be reduced to around 3%, roughly around the level considered neutral for economic growth.
But the Fed’s trajectory has repeatedly blindsided investors since the pandemic. Because they expected the increase in inflation to be short-lived, they underestimated how high interest rates would rise. Then they prematurely bet that the price was about to reverse, hitting them with new rounds of losses when it wasn’t.
That has cast some doubt on whether bond prices have risen too far again. Two-year Treasury yields, which closely match the Fed’s key policy rate, have fallen from more than 5% at the end of April to about 3.7% – enough to explain the Fed’s five quarter-point moves. Cheaper borrowing costs have also trickled down to corporate bonds and stock prices, easing financial conditions without any action from the Fed.
“The Fed needs to cut spending, we all know that, but the question is at what pace,” said John Madziyire, senior portfolio manager at Vanguard, which manages $9.7 trillion in assets. He said his firm has taken a “tactical short position” toward the bond market since the recent rally.
“If the Fed were to become aggressive and implement cuts of 50 basis points,” he said, “which would make financial conditions even looser, we run the risk of a new acceleration of inflation.”
So far, though, inflation is moving in the right direction: On Wednesday, the Labor Department is expected to report that the consumer price index rose 2.6% in August from a year earlier, according to the average forecast of economists polled by Bloomberg. That would be the smallest increase since 2021. There will be little new guidance from Fed officials, who are in the traditional blackout period ahead of the Sept. 17-18 meeting.
The bank’s trajectory will depend on whether the Fed pulls the economy into a soft landing or is forced to shift into recession-fighting mode, as it did during the Wall Street credit crisis or after the collapse of the dot-com bubble. At this point, economists are largely predicting that the economy will avoid a contraction, leaving stocks close to record highs despite the recent slump.
What Bloomberg Strategists Say:
“There is very little chance that the Federal Reserve will cut by 50 basis points on September 18 based on an unemployment rate of 4.2%. Yet the two-year interest rate fell. The conclusion, then, is that pricing for government bond yields up to two years is very rich and we are likely to see them rise from this point as reality filters through.”
– Ed Harrison, macro strategist
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JPMorgan’s Michele, the chief investment officer for global fixed income, expects the Fed will ultimately only need to cut its benchmark by 75 to 125 basis points, seeing a parallel with what happened in the mid-1990s. At the time, the economy continued to grow even after the central bank doubled interest rates to 6%, which received only a small boost.
“There has only been one soft landing that we can all agree on, and that was 1995,” he said. “I see many similarities with this time.”
At Nuveen, Chief Investment Officer Saira Malik also doubts the extent to which the market is ahead of the Fed. That has pushed U.S. Treasuries to gains over the past four months, marking the longest winning streak since 2021, before the start of Fed rate hikes.
But she thinks the market is primed for some disappointment. “The Fed will move slower rather than faster because the economy is not on the cusp of a recession,” she said, predicting that 10-year yields could rise again to 4% from about 3.7% now. “Government bonds have moved a bit too far and too fast.”
What to watch
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Economic data:
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September 9: Wholesale supplies; New York Fed 1-year inflation expectations; consumer credit
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September 10: NFIB optimism for small businesses
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September 11: MBA Mortgage Applications; consumer price index; real average earnings
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September 12: Producer Price Index; unemployment claims; change in household net worth; monthly budget overview
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September 13: Import and Export Price Index; University of Michigan sentiment/current conditions/expectations
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Fed Calendar:
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Auction calendar:
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September 9: 13 and 26 week bills
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September 10: 42 days of cash management accounts; 3-year notes
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September 11: 17 weeks’ bills; Reopening of 10-year notes
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September 12: 4, 8 week bills; Reopening of 30-year bonds
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–With help from Kristine Aquino and Ye Xie.
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