Uncertainty over the Fed's rate cut prospects intensifies market volatility, investors turn to medium-term bonds
With increasing uncertainty about the prospect of a rate cut by the Federal Reserve, bond investors are taking defensive measures. Surprising inflation data and weak labor market data have led traders to reduce bets on a Fed rate cut, pushing US bond yields to their highest level since July. Asset management companies such as BlackRock and PIMCO are advising investors to shift to five-year bonds to reduce risk. The market expects the Fed to cut rates by 45 basis points at the upcoming policy meeting, and market volatility is expected to remain high in the coming weeks
According to the Zhitong Finance and Economics APP, as the outlook for the Fed's interest rate cuts becomes more uncertain, bond investors are taking defensive measures. Last week's release of unexpectedly high inflation data and weak labor market data led traders to reduce their bets on the extent of Fed rate cuts for the remainder of 2024, pushing U.S. bond yields to their highest levels since July. In addition, a closely watched measure of expected volatility in U.S. bonds also rose to its highest level since January.
Against this backdrop, investors are finding it difficult to decide where to allocate cash in the world's largest bond market. To mitigate economic resilience, potential fiscal shocks, or vulnerabilities arising from U.S. election turmoil, asset management giants such as BlackRock, Pacific Investment Management Company (PIMCO), and UBS Global Wealth Management advocate buying five-year bonds, as five-year bonds are less sensitive to such risks compared to short-term or long-term bonds.
Solita Marcelli, Chief Investment Officer for the Americas at UBS Global Wealth Management, recommends investing in medium-term bonds, such as five-year U.S. Treasuries and investment-grade corporate bonds. She stated, "We continue to advise investors to prepare for a low interest rate environment by investing excess cash, money market assets, and maturing time deposits in assets that can provide more sustainable income."
Bond traders are currently betting that the Fed will cut rates by a cumulative 45 basis points at the next two policy meetings, lower than the 50 basis points bet before the September non-farm payrolls report was released. Meanwhile, options trading bets on another rate cut this year, with a more complex options trading bet on a further 25 basis point cut this year and a pause in rate cuts early next year.
In the coming weeks, the market still has significant volatility, and this is not only related to the U.S. election - the election will determine investors' expectations for U.S. fiscal policy. The ICE BofA Move Index, which tracks volatility in expected returns based on options, is just a step away from its 2024 high, indicating that investors expect turbulence to persist.
As investors await the U.S. Treasury's quarterly bill and bond sales, next month's employment report, and the rate decision announced by the Fed on November 7, interest rate volatility may continue for several weeks. Citadel Securities has warned clients to prepare for "significant future volatility" in the bond market. The company expects the Fed to cut rates by another 25 basis points in 2024.
Investors expect the Fed to further ease rate constraints in the coming months to ensure a soft landing for the economy. David Rogal, portfolio manager at BlackRock's Fixed Income Department, said, "As the election enters the option value window, implied volatility will rise." The company prefers medium-term U.S. bonds, as it believes that as long as inflation cools down, the Fed will implement a "rebalancing cycle," adjusting policy rates from 5% to a range between 3.5% and 4% Investor concerns about the continuously rising US deficit causing trouble for long-term US bonds are expected to help establish the "sweet spot" status of the five-year US Treasury bonds. Anmol Sinha, investment director of Capital Group's $91.4 billion bond fund, stated, "The shorter end of the yield curve, specifically the five-year or longer part, currently seems more attractive to us." He added that their positions would benefit from "more pronounced growth slowdown, economic recession, or negative shocks," as well as concerns about increasing fiscal deficits and upcoming government bond supply in a backdrop where long-term bond risk premiums are not significant.
Nevertheless, with the yield on the ten-year US Treasury approaching 4.1%, the sell-off following the release of employment data has also pushed the ten-year US Treasury into a "buy zone" for some long-term investors. Roger Hallam, global head of rates at Vanguard, stated, "Our core view is that due to the Fed's policy remaining restrictive, the economy will indeed slow down next year. This means that when the yield on the ten-year US Treasury is above 4%, there is an opportunity to start extending the duration of our portfolio, while considering the impulse of downward growth next year." He added that this would allow the company to gradually shift towards holding more bonds.
It is reported that since early September, Vanguard has also benefited from tactical short positions on US Treasuries as yields began to rise. The company is still engaging in these short-term trades, although the scale has been reduced from the initial levels