Bond market debates when the cutting starts


Vigilant approach: Powell (right) during a discussion with Helene Gayle, president of Spelman College, in Atlanta. The Fed chairman pushes back against Wall Street’s growing expectations of interest rate cuts in the first half of 2024. — Bloomberg

NEW YORK: A torrid bond market rally shows traders are convinced the Federal Reserve’s (Fed) 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.

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, chairman Jerome Powell last Friday said that while the policy was well into restrictive territory, it was “premature” at this stage to speculate on when the 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 US$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.”

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.

“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.”

Anna Wong, Eliza Winger, Estelle Ou and Stuart Paul of Bloomberg Economics said: “Our baseline is that unemployment should increase persistently in 2024, approaching 5% by the end of the year, 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.”

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, said he expects yields to head higher in the weeks ahead after investors “binged on returns” in November.

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

Data this week showed that the 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 said 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. — Bloomberg

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