Is the US bond market betting on a rate cut of over 2% within a year, destined to be swept away by this week's non-farm payroll report?

Bond prices are rising because the market expects the Federal Reserve to start cutting interest rates soon to combat a recession, which brings a risk that traders may once again underestimate the strength of the U.S. economy.

On Tuesday, U.S. bond prices continued to rise, with the yield on the two-year Treasury falling from over 5% at the end of April to around 3.85%. The past four months of gains mark the longest continuous increase since 2021. This is due to market expectations that the Federal Reserve will cut the benchmark interest rate by over two percentage points in the next 12 months, which would be the largest cut since the 1980s apart from during economic downturns.

For those bullish on bonds, this poses a risk: if the labor market, which significantly cooled in July, still shows resilience, the Fed may cut rates at a more moderate pace. The first major test will come on Friday when the U.S. government releases the nonfarm payroll data for August. Economists expect the data to show a rebound in job growth and a decrease in the unemployment rate.

Ed Al-Hussainy, the rate strategist at Columbia Threadneedle Investments, said, "If you missed the big rally, chasing it now is a bit dangerous."

"We are considering the possibility of a stable or rapidly deteriorating job market. This is the debate for the rest of the year." While he still leans towards holding a bullish position on bonds, he stated, "This is not an unquestionable trade."

Since the end of April, U.S. bond yields have exceeded 6% as investors anticipate that cooling inflation will prompt policymakers to start lowering their key policy rates from their highest levels in over 20 years. This rebound is similar to the one that occurred at the end of last year, but it reversed when the Fed did not act as quickly or aggressively as expected.

The July employment report from the U.S. Department of Labor showed the unemployment rate rising to a near three-year high, with job growth at one of its weakest points since the pandemic began. This raised concerns that the Fed waited too long to ease policy and that the U.S. economy was slowly heading towards a recession. However, these concerns have now subsided. For example, economists at Goldman Sachs have reduced the likelihood of an economic recession next year to 20%. Nevertheless, at the recent Jackson Hole central bank symposium, Fed Chair Powell hinted that the primary focus has shifted from combating inflation to protecting employment, stating that further cooling of the labor market would be "unwelcome." He did not use the term "gradual" to describe the pace of future rate cuts, leading some investors to believe that this opens the door to rapid rate cuts.

Traders now expect the Fed to cut rates by a full percentage point by the end of this year, meaning that in the remaining three meetings in 2024, one of them will involve a 50 basis point cut.

It is important to note that this does not mean investors believe an economic recession is inevitable. In fact, the market expects the U.S. to avoid a crisis, keeping the S&P 500 index not far from its historical highs. The Fed has raised rates so high that it needs to significantly lower rates to approach the neutral rate for economic growth, currently estimated at around 3% The Federal Reserve's benchmark interest rate is currently between 5.25% and 5.5%.

However, as policymakers remain concerned about the recent surge in inflation, the question is whether the labor market is weak enough to support those expectations of easing. The signals are mixed. While a recent consumer survey by the World Business Federation showed that job opportunities are not so "abundant," the number of initial jobless claims has remained stable over the past few months. Economists expect that the employment report on September 6 will show that job growth has accelerated from 114,000 to 165,000, and the unemployment rate has dropped from 4.3% to 4.2%.

Therefore, some investors and strategists tend to believe that the bond rally will fade. Strategists at Deutsche Bank advised clients to sell 10-year U.S. Treasuries on August 26, with a target yield of 4.1%. It was around 3.83% on Tuesday.

Bloomberg strategist Simon White said, "Considering that the possibility of a recession in the next 3-4 months seems smaller, it is difficult to see that the expectation of a rate cut of more than 200 basis points is correct from an objective point of view. Economic development has just slowed relatively, and it is only when the market rapidly declines, as we have recently seen, triggering a feedback loop of recession, that there is reason to expect a significant rate cut."

In addition to the stability of initial jobless claims, strategists also pointed out that there is a seasonal trend of rising bond yields in September, as corporate bond issuances typically increase after a summer lull, putting pressure on the market.

Over the past decade, September has been the worst month for bond investors. The 10-year U.S. Treasury yield has risen in 8 out of the past 10 years in that month, with an average increase of 18 basis points. Leslie Falconio, Head of Taxable Fixed Income Strategy at UBS Global Wealth Management, said, "We believe the market is priced too high, too early. We still think a soft landing is a possible outcome. We will increase our rate risk exposure but will wait for better levels."