Bond Market Euphoria Shifts to Debate Over How Low Fed Will Need to Go

A torrid bond-market rally shows traders are convinced the Federal Reserve’s rate-rising cycle is over. The debate now turns to when central bankers start cutting, and by how much.

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Bloomberg News

Michael Mackenzie and Liz Capo McCormick

Published Dec 03, 2023 • 4 minute read

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(Bloomberg) — A torrid bond-market rally shows traders are convinced the Federal Reserve’s rate-rising cycle is over. The debate now turns to when central bankers start cutting, and by how much.

At issue is whether the economy settles in for a soft landing or spirals into something worse. Both scenarios suggest rate cuts are coming, possibly as soon as March. Current market expectations call for at least 1.25 percentage points of easing next year, a trend that would seem to clear a path for lower yields and an extended rally.

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That doesn’t rule out further bouts of volatility. Conflicting data may raise doubts, and Fed officials are likely to keep reminding the market that they are in no hurry to ease. Completing a big week of Fed speak before a customary pre-meeting communications blackout period begins, chair Jerome Powell on Friday said that while policy was well into restrictive territory, it was “premature” at this stage to speculate on when policy might ease. His pushback didn’t stop bond traders from sending the market even higher.

US Treasuries may well have moved too quickly, and traders have been burned before betting on a pivot prematurely. But there is a sense that yields have peaked for the cycle, and that softening data will at some point compel a chunk of the near $6 trillion of record cash sitting in money market funds into longer-dated Treasury yields above 4%. Even after a 60 basis-point drop last month, benchmark Treasury yields remain notably above the lows set earlier this year, when recession fears were fanned by US bank failures.

“The Fed has ratified market moves by saying the data has softened and that has given the market more comfort and they tend to run with narratives and take things a little too far,” said Michael Cudzil, portfolio manager at Pimco. “There is also a possibility that the slowing data is something more nefarious.”

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A barrage of data next week will test the mettle of bond bulls, culminating in the latest US employment report. Economists surveyed by Bloomberg expect a rebound in hiring for November, to 200,000 from the prior month’s 150,000, as striking workers return to their jobs. The unemployment rate is forecast to have held steady at 3.9% while wages are expected to moderate a touch to an annual pace of 4%.

With inflation coming down faster than central bank officials expected, it reinforces the mood “that the Fed’s last rate hike was July,” Kelsey Berro, fixed-income portfolio manager at JPMorgan Asset Management, told Bloomberg Television. While yields might move higher on any given day, “we can move a lot lower if next year we are looking at rate cuts.”

Looking ahead, upcoming US consumer inflation data and the start of the Fed’s final two-day meeting for the year are the next hurdles beyond the jobs report. How the Fed frames its outlook for rate policy ending next year and 2025 via its “dot-plot” could inject some uncertainty into a market that has run ahead of the central bank’s current forecast of just half a point in easing over the coming 12 months.

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“You can disagree with the magnitude, not the direction of the decline in Treasury yields,” said Pimco’s Cudzil. “A 4.25% or a 4.5% 10-year yield is long-term attractive on a historical basis.”

What Bloomberg Economics Says…

“Our baseline is that unemployment should increase persistently in 2024, approaching 5% by year-end – a mild recession by historical standards. We expect the Fed will have enough clarity about the downturn to cut rates for the first time in March 2024. The Fed likely will cut rates by a total of 125 basis points in 2024 and another 125 basis points in 2025.”

— Anna Wong, Eliza Winger, Estelle Ou and Stuart Paul, BE economists

Click here to read the full report

For much of the year, the bond market and investment returns have been restrained by expectations of the Fed either keeping interest-rate policy “higher for longer” or having to come back and push up borrowing costs. Now, the Treasury market senses a clearer path. Did it get ahead of itself?

Mark Dowding, the London-based chief investment officer at RBC BlueBay Asset Management, says he expects yields to head higher in the weeks ahead after investors “binged on returns” in November.

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“After having been constructive on duration in the beginning of November, we’ve taken profits as yields have fallen, and moved over the course of the last week to a short position,” Dowding said.

Data this week showed that core personal consumption expenditures price index, which strips out the volatile food and energy components, rose in October on an annual basis of 3.5%. While this preferred Fed gauge of underlying inflation is moving in the right direction, Dowding says the Fed likely won’t cut rates until it’s below 3% — which RBC BlueBay doesn’t see happening until the second half.

“We view the market as being premature in front-running the Fed,” he said.

What to Watch

Economic data: Dec. 4: Factory orders; durable goods orders; capital goods ordersDec. 5: S&P Global US services, composite PMIs; Jolts jobs openings; ISM services indexDec. 6: MBA mortgage applications; ADP employment; nonfarm productivity; unit labor costs; trade balanceDec. 7: Initial jobless claims; Challenger job cuts; wholesale trade and inventories; consumer creditDec. 8: Nonfarm payrolls including unemployment rate and wage growth; U. of Michigan consumer sentiment and inflation expectationsFed Calendar: Federal Reserve enters communications blackout before Dec 12/13 policy meetingAuction calendar: Dec. 4: 13-, 26-week billsDec. 5: 42-day cash management billsDec. 6: 17-week bills;Dec. 7: 4-, 8-week bills

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