The bond market's bet is too aggressive, be careful as the expectation of a Fed rate cut may rise again!

Bond traders who have been frequently frustrated in betting on the Fed's rate hike path now find the prospect of a rate cut equally confusing, unsure if the market's rate cut expectations have gone too far.

Jamie Patton, Co-Head of Global Rates at TCW Group Inc., believes that even now the financial markets have not fully priced in the Fed's dovish policy, leaving more room for short-term U.S. Treasury bonds to rebound. "The Fed will have to lower rates faster and more aggressively than the market is pricing in," she said.

On the other hand, Bob Michele, Chief Investment Officer at Morgan Stanley, has a different view. He bets that with the continued economic growth (albeit at a slower pace), the bond market is far ahead of the Fed. Therefore, he prefers corporate bonds as they offer higher yields compared to U.S. Treasuries. "I don't see anything broken (in terms of economic growth)," he said.

The biggest risk investors face is the possibility that the market's rate cut expectations for the Fed may be excessive.

The Fed is almost certain to begin cutting rates at its policy meeting this month, marking its first rate cut since 2020. As traders try to get ahead, the prospect alone has already caused bond prices to soar, posing the risk of the market repeating past mistakes. The economy in the post-pandemic era has consistently surprised both the Fed and Wall Street forecasters with its resilience.

On Monday, U.S. Treasuries fell, pushing yields up by as much as 5 basis points, as the latest U.S. Labor Department employment report highlighted uncertainty about the rate cut outlook. Employers added 142,000 jobs in August at a pace lower than expected, ending the weakest three-month job growth since mid-2020. However, the slowdown is not enough to determine how quickly or by how much the Fed may ease policy in the coming months.

Traders still believe the Fed is most likely to cut its target rate (currently at 5.25%-5.5%) by 25 basis points this month, although analysts at Citigroup and some other banks are betting on a 50 basis point cut. The swap market also expects the Fed to lower rates to around 3% by mid-2025, roughly approaching the level considered neutral for economic growth.

Swap traders are betting that the Fed will cut rates by nearly 240 basis points by September next year.

However, since the pandemic, the Fed's policy trajectory has repeatedly caught traders off guard. They initially expected the surge in inflation to be temporary and underestimated how high rates would go. Then, they prematurely bet that the Fed was ready to reverse policy, which turned out not to be the case, leading to another round of losses.

This has raised doubts about whether the rally in bond prices has once again gone too far. The yield on the two-year U.S. Treasury note closely tied to the Fed's key policy rate has dropped from over 5% in late April to around 3.7%, **enough to reflect the Fed's 5 consecutive 25 basis point rate cuts. Cheaper borrowing costs have also impacted corporate bond and stock prices, easing financial conditions in the absence of any action by the Fed Managing $9.7 trillion in assets, Vanguard's senior portfolio manager John Madziyire said, "We all know that the Fed needs to cut rates, but the question is the pace of the rate cuts." He mentioned that since the recent rebound, his company has taken a "tactically bearish bias" towards the bond market.

"If the Fed becomes aggressive and starts cutting rates by 50 basis points, making financial conditions even looser, then inflation could accelerate again," he said.

However, so far, inflation has been moving in the right direction. According to a survey of economists by Bloomberg, the median forecast expects the Labor Department to report a 2.6% year-on-year increase in the Consumer Price Index (CPI) for August on Wednesday. This would be the smallest increase since 2021. Fed officials are not expected to provide any new guidance as they are in the traditional pre-meeting blackout period.

The Fed's policy trajectory will depend on whether it can achieve a soft landing for the economy or be forced to shift towards a recession-fighting mode, similar to what was done after the Wall Street credit crisis or the bursting of the internet bubble. Currently, economists largely predict that the U.S. economy will avoid contraction, despite recent stock market volatility, with the stock market still not far from its historical highs.

Bloomberg macro strategist Ed Harrison said, "With a 4.2% unemployment rate, the likelihood of the Fed cutting rates by 50 basis points in September is low. However, the two-year U.S. Treasury yield continues to decline. Therefore, the conclusion is that the pricing of the two-year U.S. Treasury yield for rate cuts is very high, and as the market gradually digests the reality, we may see it start to rise."

Michele expects that the Fed will ultimately only need to lower the benchmark interest rate by 75 to 125 basis points, similar to what happened in the mid-1990s. At that time, even after the Fed doubled rates to 6%, the economy continued to expand, with rates only slightly lowered.

She said, "There was only one widely recognized soft landing, and that was in 1995. This time has many similarities to that period."

Nuveen's Chief Investment Officer Saira Malik also expressed doubts about how much the market is ahead of the Fed. This has driven U.S. Treasury yields to rise over the past four months, marking the longest streak since before the Fed began raising rates in 2021.

But she believes the market is ready for disappointment. "The Fed will slow down rather than speed up because the economy is not on the brink of a recession," she said, predicting that the 10-year U.S. Treasury yield could rise from around 3.7% currently to 4%. "The movement in U.S. Treasuries has gone a bit too far, too fast."