Bond market bets on sharp reversal! Will the Federal Reserve need to be cautious about inflation?

Federal Reserve Chairman Powell seems to have indeed sounded the alarm in the bond market. In mid-September, the Federal Reserve led by him did two things that should have been good news for bonds on the surface: a significant rate cut and an indication of further cuts in the future. However, since that day, the market that supposedly supports all other asset classes globally has started to decline.

The 10-year U.S. Treasury yield has risen to over 4%, with Steven Major of HSBC stating that the U.S. bonds have retraced about 40% of the gains since 2024, making him one of the more prominent bond analysts in major banks.

"That's a big move," he said. "In just a few weeks, U.S. bonds have retraced most of the gains from the previous six months."

This looks like a typical case of "buy the rumor, sell the fact" as traders say. The rate cut was already priced into the U.S. bond market before it happened, and now this bet is being frustrated, especially by further strong employment data.

In a sense, this is good news. It means that in the recent divergence between the optimistic stock market and the pessimistic bond market, the stock market is winning. Those predicting an economic recession will have to continue waiting for their day to come.

The not-so-good news is that this indicates investors believe the Federal Reserve has let inflation run. John Butler, Global Macro Strategist at Wellington Management, which manages around $1.3 trillion in assets, said, "When the first signs of economic slowdown appear, the Fed is quick to cut rates."

Powell is one of those who emphasizes encouraging inflation trends but is not one of the policymakers who believe the job is done. Instead, the risk balance has tilted enough for the Fed to consider a significant rate cut as a cautious move to protect the labor market, which is the other half of the Fed's mission.

However, the market is more skeptical. They believe that despite strong economic growth, the Fed is cutting rates, risking overstimulating demand and reigniting inflation.

Drawing this conclusion may still be premature. But for Butler, all of this indicates that both monetary and fiscal policymakers are stuck in old ways of thinking.

"When the ground beneath us is shifting, the market has been in turmoil," he said. Labor has more bargaining power in wages and working conditions, a breakthrough in the past twenty years or so.

Butler said, "This deprives fiscal and monetary policymakers of a 'free lunch.' In the past, governments could 'increase debt without consequences,' believing that global investors would continue to absorb the bonds they issued. Meanwhile, the Fed could maintain low borrowing costs, believing the risk of surging inflation was minimal."

At some point, investors may grow tired of all the additional debt and ongoing inflation threats, demanding higher returns. This persistent risk becomes more urgent whenever bond prices fall for any reason.

The first major test in this regard will come from the UK budget, where Chancellor Rishi Sunak needs to convince bond investors that she can borrow more money within a credible new "fence." The scale of fiscal concerns in the UK, to some extent, has been exaggerated by the gravitational pull of the decline in US Treasury bonds, but this concern is real, especially since the former Prime Minister's "mini-budget" was proposed just two years ago, igniting the fuse of UK debt.

"UK government bonds look cheap," said Ben Lord, bond fund manager at M&G Investments. "I want to buy, but the risk is that the UK is very close to a situation similar to the 'mini-budget'."

Similarly, the new round of bond price declines comes at an awkward time with the upcoming US election. If the Republicans win big in an already overheated economy, the argument for the Fed acting too early will be even louder.

Now, whether the turmoil in the entire bond market will escalate into a more serious issue is mainly in the hands of politicians. Any frightened investors may find that these politicians are pushing open a door that is already slightly ajar