Another Subversion! The "No Landing Theory" of the U.S. Economy Resurges, Interest Rate Cuts No Longer Need Shooting Stars

In recent months, the scenario of "no landing" - that is, the US economy continues to grow, inflation is picking up again, and the Federal Reserve has almost no room to cut interest rates - has basically disappeared from the bond market discussion. However, all it takes is a stunning employment report to revive it.

Data shows that last month, the pace of job growth in the US was the fastest in 6 months, with the US unemployment rate unexpectedly dropping and wages rising. These factors have pushed up US Treasury yields, prompting investors to frantically reverse bets on the Fed cutting rates by 50 basis points as early as next month.

This is the latest painful adjustment for traders, who had been preparing for economic slowdown, mild inflation, and significant rate cuts by buying large amounts of short-term US Treasuries sensitive to Fed rates.

However, last Friday's non-farm payroll report reignited concerns about overheating, disrupting the rally in US Treasuries that had pushed the 2-year bond yield to multi-year lows.

"Painful trading has been due to the market reducing rate cut pricing, leading to an increase in front-end rates," said George Catrambone, head of fixed income at Deutsche Bank Americas. "The possible scenario is that the Fed either stops cutting rates or actually finds itself having to hike again."

Recent market debates have mostly focused on whether the economy can achieve a "soft landing," where the economy slows down without falling into a recession, or whether it will turn into a "hard landing," a severe recession.

The Fed itself has hinted at shifting its focus to preventing deterioration in the job market, having worked for over two years to combat inflation. Its rate cut shift began with a 50 basis point cut in September.

But last Friday's non-farm payroll report provided ammunition for those criticizing the Fed for cutting rates while the stock market hits new highs, the economy grows steadily, and inflation has not returned to target. In short, this is a "no landing" situation.

Some prominent investors and economists, including Stanley Druckenmiller and Mohamed El-Erian, have warned that the Fed should not be constrained by market expectations for rate cuts or its own forecasts. El-Erian warned that "inflation has not disappeared." Former Treasury Secretary Larry Summers said in an article last Friday that "no landing" and "hard landing" are risks the Fed must consider, calling last month's significant rate cut "a mistake."

For some, the Fed's excessive rate cut last month, coupled with China's unexpected stimulus measures, has tilted the balance of growth concerns in another direction.

"There should be no reason to cut rates by 50 basis points now," said Tracy Chen, portfolio manager at Brandywine Global Investment Management. "The Fed's loose policy and China's stimulus measures increase the possibility of no landing."

Meanwhile, inflation concerns have resurfaced after a surge in oil prices. As a measure of bond traders' inflation expectations, the 10-year breakeven rate reached a two-month high, rebounding from a three-year low in mid-September Traders are pricing in a 24 basis point rate cut for the November FOMC meeting, indicating that a 25 basis point cut is no longer certain.

By October 2025, the market has priced in a total of 150 basis points of easing, which is less than the expected 200 basis points cut by the end of September.

The reduction in rate cut expectations has poured cold water on the bond buying frenzy, which has helped US Treasury bonds achieve growth for five consecutive months, marking the best performance since 2010. Since the last FOMC meeting, the yield on the 10-year US Treasury bond has risen by over 30 basis points, approaching 4% for the first time since August.

"The Fed has emphasized the importance of the labor market in its dual mandate, which prompted the significant rate cut last month, and now we have evidence that the labor market is in good shape," said Baylor Lancaster-Samuel, Chief Investment Officer at Amerant Investments Inc. "This is definitely a bit of a 'be careful what you wish for' situation."

This shift in narrative has also disrupted a popular strategy of betting on an aggressive Fed easing policy known as steepening the curve. In this strategy, traders bet that short-term US bonds will outperform long-term US bonds.

Contrary to expectations, the yield on the two-year US Treasury bond rose by 36 basis points last week, the most since June 2022. The two-year yield reached 3.9%, only 6 basis points below the 10-year yield, narrowing the gap from 22 basis points at the end of September.

Bloomberg strategist Alyce Andres said signs of inflation are emerging, concerns about a labor market collapse are minimal, the economic momentum is positive, and there may be a complete bypass of a soft landing, choosing not to land.

With renewed focus on inflation, this week's Consumer Price Index (CPI) report is highly anticipated. Core CPI is expected to have slowed to 0.2% last month, down from a 0.3% increase in September. Fed Governor Waller said that inflation data he received shortly before the September 18 policy meeting ultimately led him to support a 50 basis point rate cut.

It is certain that the current market pricing indicates that a soft landing scenario is still the baseline for investors. The 2.2% 10-year breakeven rate still broadly aligns with the Fed's 2% inflation target.

The swap market shows traders expect the Fed to end its easing cycle in 2027, with rates expected to reach around 2.9%, consistent with the widely believed neutral rate level.

Jamie Patton, Co-Head of Global Rates at TCW, stated that the latest employment data is not sufficient to change the necessity for the Fed to continue firmly on the path of easing policy, as all data, including a decrease in resignation rates and an increase in auto loan and credit card default rates, indicate that the job market is softening and there are downside risks to the economy "A single data point has not changed our macro view that the labor market is weakening overall," Patton said.

She said she took advantage of last Friday's sell-off to buy more two-year and five-year bonds, increasing her steepening position.

The rekindling of inflation fears may prevent the Fed from cutting rates, but this would increase the risk of the Fed keeping borrowing costs "too high for too long" and ultimately leading to a larger recession.

Earlier, Chicago Fed President Gulspie praised the strong September jobs report but warned against overemphasizing data from a single month. Gulspie stated that inflation is trending towards the Fed's 2% target level, the employment situation is also good, and Fed officials should strive to "freeze" them in their current positions. He did not indicate that he believed the Fed should abandon further rate cuts.

He stated that the median estimate of the 19 Fed policymakers is that rates will fall to 3.4% by the end of next year and to 2.9% by the end of 2026, which seems "quite appropriate." He mentioned that the neutral level of rates may have risen, but the Fed has time to determine where this level is. "I think it's definitely higher than the zero rates we had for many years before the COVID-19 pandemic."

Fed officials have been raising their estimates for the long-term neutral rate, with the median estimate now at 2.9%, higher than the pre-pandemic forecast of 2.5%. The neutral rate can only be estimated and not measured