(Bloomberg) — The world’s biggest bond market is reaching a turning point, with US Treasuries wiping out their 2024 losses as traders start to embrace the idea of three interest-rate cuts this year.
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Optimism tied to an ebb in inflation was on full display this week in US government debt, with yields across the curve slumping as the data was seen supporting the case for lower borrowing costs as soon as September. Two-year Treasury yields — more sensitive than longer maturities to Federal Reserve monetary policy — are down 15 basis points this week to 4.45%, the lowest since March.
“All signs point to the Fed starting rate cuts in September,” said Sinead Colton Grant, chief investment officer at BNY Wealth. “You are seeing a market participant reaction to CPI on the back of a softer June labor market report” and Fed Chair Jerome Powell’s recent testimony to US lawmakers.
Powell told lawmakers this week that officials are increasingly wary of potential risks to the labor market, while waiting for more evidence of inflation slowdown. On Thursday, data showed that the consumer price index increased in June at the slowed pace in three years and fueled a rally in the bond market.
While figures released on Friday showed US producer prices climbed in June slightly more than forecast, market participants focused more on a drop in consumer sentiment. Yields were broadly lower Friday.
The rally this week has helped the Bloomberg US Treasury Index to climb 0.3% this year, as of Thursday’s close, erasing a year-to-date loss of as much as 3.4% in April.
“Clearly a lot of people missed the yield highs at 4.75%, and there is a bit more FOMO — but also more conviction that the cycle is moving in the direction of lower yields,” said John Madziyire, senior portfolio manager at Vanguard. “Now that the Fed is in play, you want to extend longer out the curve.”
Interest-rate swaps showed traders have all but fully priced in a quarter-point rate cut by the September meeting and are targeting more than two reductions this year. On Friday, Barclays economists tweaked their forecast for Fed policy, predicting a second interest-rate cut in December in addition to the one they were already expecting in September.
Some have begun to contemplate the potential for a half-percentage-point cut in September, buying October federal funds futures contracts in large size at prices that only make sense if more people buy into the idea that the Fed could begin its first easing cycle in years with a supersized move.
What Bloomberg strategists say…
“A drip drip of weak economic data and yesterday’s soft CPI will make it hard for Treasury bears to gain sway. But the steepener is still the trade to watch.”
— Edward Harrison, The Everything Risk newsletter. More on MLIV.
Traders are now looking ahead to readings of the Fed’s preferred measure of underlying inflation — the so-called personal consumption expenditures price index — and more information on the job market.
“Generally, we think rates will continue moving lower into easing,” said Molly McGown, a rate strategist at TD Securities.
While the market is all but certain about the September rate cut, Mohamed El-Erian, the president of Queens’ College, urged caution that the upcoming presidential election may complicate the Fed’s decision. Former President Donald Trump, who gained momentum after President Joe Biden’s poor performance at a debate, has floated ideas to impose steep tariffs and crack down on immigration. Both policies are seen fueling inflation.
The political factor has been one driving force in the bond market in recent weeks. Short-term bonds have outperform longer-maturity debt — a dynamic known as steepening yield curve — since the debate, reflecting concern Trump’s policies may lead to higher risk premium on longer-maturity Treasuries.
The move has gained further momentum this week as expectations of rate cuts pushed the short-term rates down more than the longer-dated bonds. At 4.4%, the 30-year yield is about 29 basis points higher than five-year rate, nearing the highest since February.
“I can’t say investors have a strong conviction on duration, but curve steepeners remains a favorite trade,” said Subadra Rajappa, head of US rates strategy at Societe Generale.
–With assistance from Edward Bolingbroke.
(Adds Barclays forecast in eighth paragraph and updates prices.)
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