The U.S. bond market has "voted": the Federal Reserve will send a "dovish" signal!

Bond investors expect the Federal Reserve to keep interest rates unchanged this week, but signal an upcoming rate cut, so they are betting that the U.S. bond yield curve will become less inverted and eventually return to normal.

This strategy involves bullish bets on short-term U.S. bonds and reducing exposure to long-term U.S. bonds, a trade known as "steepening the yield curve," resulting in pushing the yield of long-term U.S. bonds higher than that of short-term U.S. bonds. Investors are willing to take on longer-term risks to gain higher yields as compensation.

The closely watched 2-year/10-year U.S. bond yield curve has been inverted for two consecutive years, the longest inversion in history, with the yield spread currently at -22 basis points.

The market widely expects the Federal Reserve to maintain its overnight benchmark interest rate in the 5.25%-5.50% range for the eighth consecutive time on Thursday. Investors anticipate Fed Chairman Powell to give a "dovish" signal after the meeting, suggesting a possible rate cut as early as September, the first rate cut in four years.

Powell also has the opportunity to prepare the market at the end of August during the Jackson Hole Global Central Bank Governors Meeting. By then, more data on inflation and this Friday's July employment report may provide policymakers with the confidence they need.

According to calculations by the London Stock Exchange Group (LSEG), the interest rate futures market has priced in a total of about 68 basis points of rate cuts starting in September, a significant increase from the 30 basis points before the June meeting. It is expected that there will be about three 25 basis point rate cuts by June 2025.

In the Fed's June rate forecast, the central bank only expected one rate cut in 2024. The slowdown in U.S. inflation and the gradual loosening of the labor market have led to a shift in market rate expectations.

Greg Wilensky, Head of U.S. Fixed Income at Janus Henderson Investors, said, "The yield curve has changed significantly over the past six weeks, but we were at a similar level last October, and the inverted yield curve situation is still abnormal. We are entering a scenario where the yield curve will move towards a normal positive slope. There is still a lot of room for change." The company manages assets worth $352.6 billion.

The spread between 2-year and 10-year U.S. bond yields has narrowed by 30.4 basis points since the end of June. In recent weeks, the yield curve has mainly experienced a "bull steepening," where the decline in short-term bond yields is greater than that of long-term bond yields, a typical precursor to the Fed's rate cut cycle.

Investors were actively betting in January that the yield curve would steepen further, as the market expected multiple rate cuts in 2024, in response to the Fed's dovish turn in December last year. However, these bets were later reversed as the yield curve further flattened, attributed to unexpectedly strong economic performance and stubborn inflation Ahead of this week's Federal Reserve meeting, investors in the futures market significantly increased their net long positions in short-term US bonds, such as two-year US bonds, while their net long positions in long-term US bonds did not see a corresponding increase, and even decreased. This aligns with the "steepening bull market" strategy implemented in the past few weeks.

Data released by the US Commodity Futures Trading Commission last Friday showed that asset management companies last week increased their net long positions in two-year US bonds to historically high levels. These companies have also maintained net long positions in five-year US bond futures, reaching historically high levels in mid-July, despite a slight decrease last week.

Chip Hughey, Managing Director of the Fixed Income Department at Truist Advisory Services, stated: "It is very urgent to quickly enter the short end of the yield curve before yields start to decline more noticeably."

Mike Sanders, Portfolio Manager and Head of Fixed Income at Madison Investments, mentioned that if the Federal Reserve starts an interest rate cut cycle without an economic recession, buying bonds of any maturity or any long-term bonds may not necessarily bring you returns like betting on two to seven-year US bonds. With assets under management of $25 billion, the company is currently overweight in three to seven-year US bonds, reflecting their expectation of a decline in the yields of these bonds