There is solid evidence of a cooling labor market in the United States, and the Fed is almost certain to cut interest rates in September, despite ongoing debates over the magnitude and speed of the rate cut.

For bond traders, the magnitude and speed of the rate cut are a headache. Traders who previously misjudged the pace of Fed rate hikes are now finding it equally vexing to forecast the rate cut.

There is a serious difference of opinion in the current market. On one hand, some believe that the rate cut trades have already been executed in advance, and the significant decline in US bond yields has already priced in and absorbed the future rate cuts by the Fed. On the other hand, some believe that the Fed's rate cut may be more aggressive than market expectations, leaving room for further increases in US bonds. However, the consensus is that the future trend of US bonds will depend on the pace of rate cuts by the Fed.

Are US bonds sprinting ahead? The future trend of US bonds will depend on the pace of rate cuts by the Fed.

As the September 18th meeting of the Federal Reserve approaches, there is widespread expectation that the Fed will cut interest rates for the first time since 2020. This expectation has already driven US bonds sharply higher.

Currently, there is sensitivity towards policies.$U.S. 2-Year Treasury Notes Yield (US2Y.BD)$It has dropped from over 5% in April to around 3.7%.$U.S. 10-Year Treasury Notes Yield (US10Y.BD)$The soaring trend of the U.S. bond has already reflected the market's pricing for future Fed rate cuts. The lower borrowing cost has also promoted the rise of corporate bonds and stocks, easing the pressure on the financial market.

Some investors believe that U.S. bonds have significantly outperformed the market.

John Madziyire, senior investment manager at Vanguard, which manages $9.7 trillion in assets, said that the Fed needs to cut rates, which everyone knows, but the key is the speed. If the rate cut is too fast, it may lead to a reacceleration of inflation. He believes that the current rapid rise in the bond market has taken a tactical short-term put position.

Saira Malik, Chief Investment Officer of Nuveen, also stated that the market may be too optimistic about the speed of Fed rate cuts, and believes that the 10-year treasury notes yield may rise from the current 3.7% to around 4%. Bob Michele of JPMorgan Asset Management holds a similar view that the bond market has preempted the action of the Fed. Although the economy is slowing down, it has not deteriorated. He is more inclined to invest in higher yielding corporate bonds rather than government bonds.

But Jamie Patton of TCW Group holds a completely opposite view. Patton believes that market expectations are not sufficient, and short-term U.S. government bonds may still have room to rise. She said, "The Fed will have to cut interest rates at a faster and more aggressive pace than the market expects."

Jeffrey Rosenberg, senior portfolio manager at BlackRock, also issued a warning that the Fed's rate cuts may exceed expectations. He said that if a 50 basis point cut is made in September, it may indicate (concern for the economy), which could trigger severe market turmoil.

According to a Bloomberg article, despite market expectations for a rate cut by the Federal Reserve, previous market predictions have been proven wrong. Traders have underestimated the extent of Fed rate hikes, and then prematurely bet on a Fed policy reversal, resulting in new losses. The post-pandemic economic performance has exceeded expectations, repeatedly catching the Fed and Wall Street predictions off guard.

There are still risks in the US bond market, but the consensus among multiple analysts is that the movement of US bonds is related to the pace and extent of future rate cuts by the Federal Reserve.

What is the pace of rate cuts by the Federal Reserve?

Regarding the extent of rate cuts in September, Goldman Sachs commented in a research report that the Fed leadership believes a 25 basis point cut in September is the baseline scenario.

In our view, these remarks are consistent with our expectation that the Fed will cut rates by 25 basis points in September, but if the labor market continues to deteriorate, the leadership of the Fed will be willing to cut rates by 50 basis points in subsequent meetings.

According to The Wall Street Journal, Peter Cardillo, Chief Market Economist at Spartan Capital Securities, stated, "The fact that there were more than 0.1 million new nonfarm jobs in August weakened the likelihood of a 50 basis point rate cut by the Fed at the September meeting. However, downward revisions to the data in previous months indicate that the Fed needs to cut rates by at least 75 basis points this year." With three more Fed meetings scheduled for this year, a 25 basis point cut at each meeting would achieve the aforementioned goal.

Regarding the pace of rate cuts for the whole year, data from the Chicago Mercantile Exchange shows that although investors believe there's a higher possibility of a 25 basis point rate cut by the Fed in September, they are actually betting on a cumulative rate cut of 100 basis points or more by the end of the year.

SWhy Securities believes that the pace of rate cuts by the Federal Reserve this year will be 25 basis points followed by two more 25 basis point cuts. They point out that the pace of rate cuts by the Fed depends on the economic fundamentals. The way the economy "lands" determines the downward slope and scope of US bond yields. In the case of a recession, the Fed would make larger rate cuts. The direction of inflation is the main contradiction that drives a shift in Fed policy stance. If the forces driving inflation rebound are temporary, then rate cut trades are more likely to be repeated rather than reversed.

Editor/ping