Source: Jin10 Data

Bond prices are rising, the reason being market expectations that the Federal Reserve will soon begin to cut interest rates to combat a recession, which brings a risk that traders may once again underestimate the strength of the US economy.

The rise in US bonds continued on Tuesday, with the two-year US bond yield dropping from over 5% at the end of April to around 3.85%. The increase over the past four months is the longest continuous rise since 2021. This is due to market expectations that the Federal Reserve will cut its benchmark interest rate by more than two percentage points in the next 12 months, the largest cut since the 1980s, except during periods of economic downturn.

For bond call holders, this brings a risk: if the labor market cools significantly in July and still shows resilience, the Fed will be able to cut rates at a more moderate pace. The first major test will be announced on Friday, when the US government will release the non-farm payroll data for August. Economists expect the data to show a rebound in employment growth and a decrease in the unemployment rate.

Ed Al-Hussainy, interest rate strategist at Columbia Threadneedle Investments, said: "If you missed the sharp rise in bonds, chasing the rise now would be a bit risky."

"We are considering the possibility of a stable or rapid deterioration in the labor market. This is the debate for the remainder of the year." Although he still leans towards holding a call position on bonds, he said, "This is not an unquestionable trade."

Since the end of April, the return on US bonds has exceeded 6%, as investors anticipate that cooling inflation will prompt policymakers to start lowering their key policy rates from their multi-decade highs. This rebound is similar to the rebound that occurred at the end of last year, but then there was a reversal in US bonds rebound after it became apparent that the Federal Reserve would not act as quickly or aggressively as expected.

The US Labor Department's employment report for July showed the unemployment rate rising to a near three-year high, with employment growth at one of the weakest levels since the outbreak of the pandemic. This has raised concerns that the Fed waiting too long to start easing its policy, and the US economy is slowly heading towards a recession. However, these concerns have now faded. For example, Goldman Sachs economists have reduced the likelihood of an economic downturn next year to 20%. However, at the recent Jackson Hole central bank symposium, Fed Chairman Powell hinted that the top priority has shifted from fighting inflation to protecting employment, and that further cooling of the labor market would be "unwelcome". He did not use the word "gradual" to describe the pace of future rate cuts, and some investors believe that this move has paved the way for rapid rate cuts.

Traders now expect the Fed to cut interest rates by a full percentage point before the end of this year, which means that one of the three remaining meetings in 2024 will see a 50 basis point reduction in interest rates.

It should be noted that this does not mean that investors believe an economic recession is inevitable. In fact, the market expects the USA to potentially avoid a crisis, keeping the s&p 500 index not far from its historic high. The Fed has raised interest rates so high that it needs to significantly lower them to approach the neutral interest rate for economic growth, currently estimated at about 3%. The Fed's benchmark interest rate is currently between 5.25% and 5.5%.

However, due to policymakers' lingering concern about recent soaring inflation, the question is whether the job market is weak enough to support those loose expectations. These signals are mixed. While recent consumer surveys by large global corporate federations indicate that job opportunities are not so 'abundant', the number of initial jobless claims has remained stable over the past few months. Economists expect the employment report on September 6 to show that employment growth has accelerated from 114,000 to 165,000, and the unemployment rate has dropped from 4.3% to 4.2%.

As a result, some investors and strategists are inclined to believe that the momentum in bonds will fade. Deutsche Bank's strategist advised clients on August 26 to sell 10-year US Treasury bonds, with a target yield increase to 4.1%. It was around 3.83% on Tuesday.

Bloomberg strategist Simon White said, 'Given that the likelihood of a recession in the next 3-4 months seems to be smaller, it is difficult to objectively see that the expectation of a rate cut of over 200 basis points is correct. Economic growth has just relatively slowed down, and it is only when the market rapidly declines, as we have recently seen, triggering a feedback loop of recession, that there is reason to expect a significant rate cut.'

In addition to the stable initial jobless claims, strategists also pointed out that there is a seasonal trend of rising bond yields in September, as corporate bond issuances usually increase after the summer hiatus, adding supply pressure to the market.

In the past decade, September has been the worst month for bond investors. The yield on 10-year US Treasury bonds has risen in 8 out of the past 10 years, with an average increase of 18 basis points in that month. Leslie Falconio, Head of UBS Global Wealth Management's Taxable Fixed Income Strategy, said, 'We believe the market is overpriced and premature. We still think a soft landing is a possible outcome. We will increase the interest rate risk exposure, but will wait for better levels.'