The Fed significantly cuts interest rates, but US bonds become the biggest losers

Are U.S. Treasury Bonds the Biggest Loser of the Fed's Rate Cut?

The Federal Reserve unexpectedly cut rates by 50 basis points last week, causing a "celebration" in the U.S. stock market. However, Bloomberg macro strategist Simon White believes that this rate cut decision may lead to greater price and liquidity risks in the U.S. Treasury market, making it the biggest loser.

Nobel laureate in economics Milton Friedman once used the vivid metaphor of "fools in the shower" to describe the lag in central banks' monetary policy formulation. He believed that central bank policy adjustments often lag behind the actual economic situation due to excessive optimism, resulting in less than satisfactory policy outcomes.

This rate cut by the Federal Reserve may indeed confirm Friedman's viewpoint. In a still uncertain economic outlook, a rapid rate cut may exacerbate the term premium of long-term bonds, leading to greater liquidity risks in the U.S. Treasury market.

Rate Cut Leads to Bearish Trend in Bond Market

White believes that inflation and its volatility are the two biggest risks facing long-term bonds.

After a rate cut by the Federal Reserve, inflation volatility tends to increase significantly, much more than when raising rates or staying put.

Typically, after the Fed eases policy, the yield curve steepens, signaling a positive economic outlook. However, White believes that in the current cycle, due to liquidity and inflation risks, long-term bond yields rise, leading to a steepening yield curve, which may become a norm.

White points out that based on historical data, rate cuts usually lead to an increase in the term premium of long-term government bonds. The term premium reflects the additional yield that investors holding long-term bonds require to compensate for the uncertainty of inflation and its trends.

Moreover, there is a significant positive correlation between the unexpectedness of rate cuts and the term premium and yield curve, with a greater degree of unexpectedness leading to a steeper yield curve. Last week's rate cut decision was seen as the largest downside surprise in the past two decades outside of crises and bear markets. This uncertainty has made the market more cautious about future economic trends.

Although the Fed set the expectation of a 50 basis point rate cut, the current economic conditions do not show signs of a recession. This implies that such a large rate cut may not be necessary. White suggests that this means there is a greater possibility of an unexpected rate hike (Fed cutting rates less than market expectations), leading to an increase in the term premium and pushing long-term yields higher.

"All of this adds up to a perfect storm for long-term yields: greater uncertainty, lower rates, and the negative impact on risk assets due to rates exceeding expectations."

Increased Liquidity, Worsening Fiscal Deficit, Rising Inflation Risks... U.S. Treasury Bonds Face a More Severe Outlook

Currently, the liquidity of the U.S. Treasury market faces serious challenges. The Bloomberg Treasury Liquidity Index recently hit a new high, indicating poor liquidity in the U.S. Treasury market. Although the index has fallen from its peak, it still remains at elevated levels for most of the past 15 years

"Regardless, with the Federal Reserve's loose policy exacerbating inflation volatility, liquidity risk is bound to rise again."

Furthermore, with the federal government's fiscal deficit reaching as high as $1.5 to 2 trillion, inflation risks have significantly increased, making the liquidity outlook for the bond market even more grim.

White pointed out that over the past two years, the issuance of U.S. Treasury bonds has sharply increased to meet the expanding borrowing demand, but the current issuance has stabilized, leading to a significant extension of bond maturities.

"In the scenario of heavy government borrowing and the Federal Reserve intensifying inflation risks, the market may not necessarily be willing to continue purchasing long-term government bonds at current prices.

Therefore, as the market demands a greater safety margin for holding government debt, term premiums may rise."