The Federal Reserve will launch a "market rescue" mode? Traders are betting heavily!

Bond traders are heavily betting on a rapid deterioration of the US economy, to the extent that the Federal Reserve needs to start taking proactive monetary policy measures to avoid an economic recession.

Previous concerns about soaring inflation risks have almost disappeared, rapidly replaced by speculation that growth will stagnate unless the Fed begins to lower interest rates from their highest point in over 20 years.

This is driving one of the biggest rallies in the bond market since the banking crisis panic in March 2023. The progress is so strong that the policy-sensitive two-year US Treasury yield fell by 50 basis points last week, dropping to less than 3.9%. It has not been so significantly below the Fed's benchmark interest rate (currently around 5.3%) since the global financial crisis or the bursting of the dot-com bubble.

"The market is concerned that the Fed is behind, and we are transitioning from a soft landing to a hard landing," said Tracy Chen, portfolio manager at Brandywine Global Investment Management. "US Treasuries are now a good choice because I believe the economy will continue to slow down."

Bond traders have repeatedly made wrong judgments on interest rate trends since the end of the pandemic, sometimes overreacting and sometimes caught off guard, especially when the economy defies recession predictions or inflation exceeds expectations. By the end of 2023, bond prices also rose significantly as people believed the Fed would start easing policy, but these gains were wiped out as the economy continued to show astonishing strength.

Therefore, the latest move in the bond market may be another overzealous swing. "The market is overreacting, as we saw at the end of last year, you need more data for validation," said Kevin Flanagan, Head of Fixed Income Strategy at WisdomTree.

But sentiment shifted dramatically after a series of data showed weakness in the job market and cooling in some sectors of the economy. Last Friday, the Labor Department reported that employers created only 114,000 jobs in July, well below economists' expectations, and the unemployment rate unexpectedly rose.

The Fed's decision to once again keep interest rates unchanged sparked concerns, with worries that the Fed is reacting too slowly—similar to delaying rate hikes when inflation persisted after the end of the pandemic, especially considering that the Bank of Canada and the European Central Bank have already started easing policy.

Concerns about economic slowdown and the Fed's delayed action led to a sharp sell-off in the US stock market last week, with Berkshire Hathaway disclosing massive sales in the second quarter over the weekend, cutting its stake in Apple by nearly 50%, further dampening market sentiment.

Steve Sosnick, Chief Strategist at Interactive Brokers, said, "In the past 10 days or so, there has been an absolutely huge change in the two-year US Treasury yield. Pricing so-called safe-haven assets is very difficult, and pricing assets with high risk (stocks) is even more difficult. Warren Buffett's decision to reduce his stake in Apple also weighed on sentiment."

Larger Rate Cuts

Economists across Wall Street have begun predicting that the Fed will take a more aggressive rate-cutting pace, with economists at Citigroup and JPMorgan forecasting 50 basis points of rate cuts at the September and November meetings Last Sunday, Goldman Sachs economists raised the possibility of the United States falling into a recession next year from 15% to 25%, but stated several reasons not to worry about an economic downturn. The economy will continue to remain "overall good", there are no major financial imbalances, the Federal Reserve has significant room for interest rate cuts if needed, and can act swiftly.

Futures traders are pricing in roughly five 25 basis point rate cuts before the end of the year, indicating their expectation of unusually large 50 basis point rate cuts in the final three meetings. There has not been such a scale of rate cut action since the pandemic or credit crisis.

The rise in U.S. Treasury bonds has pushed the yield on the benchmark 10-year U.S. Treasury down to around 3.8%, the lowest level since December last year. The increase in U.S. bonds has been supported by the decline in the stock market, as some companies have released weak earnings reports, such as Intel, which also announced layoffs of thousands of employees.

Bloomberg strategist Edward Harrison said, "Locking in yields is clearly the top priority for bond investors, as more deteriorating employment evidence suggests that rates could be cut rapidly and aggressively in the coming months. Last Friday's employment report raised doubts in the bond market and exacerbated concerns about whether the Federal Reserve is currently making policy mistakes."

Kathryn Kaminski, Chief Research Strategist and Portfolio Manager at quantitative fund AlphaSimplex Group, said that due to the stock market decline and investors rushing to buy bonds before further declines in bond yields, bonds seem to have room for further gains. She stated that the company's trend-following signal has turned bullish on bonds this month, after being bearish before.

"People looking to lock in rates have created significant buying pressure, while there is also a risk-off sentiment," Kaminski said. "If we do indeed have these rate cuts before the end of the year, the 10-year U.S. Treasury yield could fall to close to 3%."

According to CME's "FedWatch", the current probability of a 25 basis point rate cut by the Federal Reserve in September is 30.5%, with a 50 basis point rate cut probability at 69.5%. The probability of a cumulative 75 basis point rate cut by November is 4.1%, a cumulative 100 basis point rate cut at 35.8%, and a cumulative 125 basis point rate cut at 60.1%