The U.S. bond market is betting on a rate cut of more than 2% this year. Is it destined to be swept by this week's non-farm payrolls?

Source: Jinshi Data

Bond prices are rising on expectations that the Federal Reserve will soon begin cutting interest rates at a recession-fighting pace, creating a risk that traders may have once again underestimated the strength of the U.S. economy.

The rally in U.S. Treasuries extended on Tuesday, with the yield on two-year Treasury notes falling to around 3.85% from more than 5% at the end of April. The rally over the past four months is the longest streak since 2021. The move comes as market expectations are that the Federal Reserve will cut its benchmark interest rate by more than two percentage points over the next 12 months, which would be the biggest cut outside of a downturn since the 1980s.

For bond bulls, this creates a risk that the Fed will be able to cut rates at a more moderate pace if the labor market, which cooled sharply in July, still shows resilience. The first big test will come on Friday, when the U.S. government releases nonfarm payrolls data for August. Economists expect the data to show a rebound in job growth and a drop in the unemployment rate.

"If you missed the big rally (in bonds), it's a little dangerous to chase it now," said Ed Al-Hussainy, interest rate strategist at Columbia Threadneedle Investments.

"We're looking at the possibility of a stable job market or a rapid deterioration. That's the debate for the rest of the year." While he still prefers to hold a bullish bond position, he said, "It's not a no-brainer trade."

Treasuries have returned more than 6% since the end of April as investors expect cooling inflation to allow policymakers to begin cutting their key policy rate from a more than 20-year high. The rally is similar to one that broke out late last year, but reversed after it became clear the Fed would not act as quickly or aggressively as expected.

The Labor Department's July jobs report showed the unemployment rate rose to a nearly three-year high and the number of employees increased at one of the weakest rates since the pandemic, which briefly raised concerns that the Fed waited too long to start easing policy and that the U.S. economy was slowly heading for a recession. But now, those concerns have faded. Economists at Goldman Sachs Group Inc., for example, have lowered the chance of a recession next year to 20%. At the recent Jackson Hole central bank symposium, however, Fed Chairman Jerome Powell signaled that the priority has shifted from fighting inflation to protecting jobs, saying a further cooling in the labor market would be "unwelcome." He did not use the word "gradual" to describe the pace of future rate cuts, a move that some investors see as opening the door to faster rate cuts.

Traders now expect the Fed to cut rates by a full percentage point by the end of the year, which would mean a 50 basis point cut at one of the three remaining meetings in 2024.

To be clear, this does not mean that investors believe a recession is inevitable.In fact, markets are expecting the U.S. to likely avoid a crisis, keeping the S&P 500 within striking distance of its all-time high. The Fed has raised interest rates so high that it would need to cut them sharply to get closer to the rate that is considered neutral for economic growth - currently estimated to be around 3%. The Fed's benchmark rate is currently between 5.25% and 5.5%.

However, with policymakers still obsessed with the recent surge in inflation, the question is whether the job market is weak enough to support those easing expectations. The signals are mixed. While the Conference Board's recent consumer survey shows that job opportunities are less "plenty," weekly initial jobless claims have remained stable over the past few months. Economists expect the Sept. 6 jobs report to show that job growth accelerated to 165,000 from 114,000 and the unemployment rate fell to 4.2% from 4.3%.

As a result, some investors and strategists are inclined to believe that the bond rally will fade. Deutsche Bank strategists on Aug. 26 advised clients to sell 10-year Treasury bonds, targeting a yield of 4.1%. It was around 3.83% on Tuesday.

Bloomberg strategist Simon White said, "Given that the probability of a recession in the next 3-4 months seems smaller, it is difficult to see from an objective perspective that expectations of a rate cut of more than 200 basis points are correct. The economy is only relatively slower, and only a rapid decline in the market, as we have seen recently, triggering a feedback loop of recession, would justify the expectation of a large rate cut."

In addition to the stable number of initial jobless claims, strategists also pointed out that bond yields have a seasonal trend of rising in September, as corporate bond issuance usually increases after a summer break, adding supply pressure to the market.

September has been the worst month for bond investors in the past decade. The 10-year Treasury yield has risen in eight of the past 10 years, climbing an average of 18 basis points."We think the market is overpriced and prematurely priced," said Leslie Falconio, head of taxable fixed income strategy at UBS Global Wealth Management.