A sharp rally in the bond market shows traders are convinced the Federal Reserve's rate-hiking cycle is over. The debate now revolves around when and by how much central bankers will start cutting interest rates.
The question is whether the economy is heading for a soft landing or sliding into something worse. Both scenarios suggest that rate cuts are imminent, possibly as early as March. Current market expectations are for at least 1.25 percentage points of easing next year, a trend that appears to pave the way for lower yields and a longer recovery.
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This does not rule out further bouts of volatility. Conflicting data could raise doubts, and Fed officials are likely to keep reminding the market that they are in no rush to ease. Wrapping up a key week of speeches from the Fed before the start of the usual blackout period for pre-meeting communications, Chairman Jerome Powell said Friday that while monetary policy was well into restrictive territory, it was “premature” to speculate about it at this point , when monetary policy could be relaxed. His resistance didn't stop bond traders from pushing the market even higher.
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Treasury bonds may have moved too quickly and traders fretted before betting on a premature pivot. However, there is a sense that yields have peaked for the cycle and that weakening data will at some point result in some of the nearly $6 trillion in record money sitting in money market funds being channeled into longer-term Treasury yields above 4%. flow. Even after a 60 basis point decline last month, benchmark Treasury yields remain well above lows hit earlier this year, when recession fears were stoked by U.S. bank failures.
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“The Fed has validated the market moves by saying the data has gotten weaker and that has given the market more comfort and they tend to rely on narratives and take things a little too far,” Michael said Cudzil, portfolio manager at Pimco. “There is also the possibility that the slowing data is something more nefarious.”
A barrage of data will test the mettle of bond bulls next week, culminating in the latest U.S. jobs report. Economists polled by Bloomberg expect hiring to rise to 200,000 in November from 150,000 the previous month as striking workers return to work. The unemployment rate is forecast to remain stable at 3.9%, while wages are expected to moderate slightly to an annual pace of 4%.
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With inflation falling faster than central bank officials expected, it is reinforcing sentiment “that the Fed's last rate hike occurred in July,” Kelsey Berro, fixed income portfolio manager at JPMorgan Asset Management, told Bloomberg Television. While yields could rise on any given day, “we could go significantly lower if we consider rate cuts next year.”
Looking ahead, the upcoming US consumer inflation data and the start of the Fed's final two-day meeting of the year are the next hurdles beyond the jobs report. The way the Fed frames its outlook for interest rate policy expiring next year and in 2025 in its “dot plot” could create some uncertainty in a market that is underperforming the central bank's current forecast of easing in the the next 12 months by only half a percentage point.
“One cannot agree with the magnitude, rather than the direction, of the decline in Treasury yields,” Pimco’s Cudzil said. “A 10-year yield of 4.25% or 4.5% is historically attractive in the long term.”
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“We assume that unemployment will rise continuously in 2024 and approach the 5 percent mark by the end of the year – a mild recession by historical standards. We expect the Fed to have enough clarity about the downturn to cut rates for the first time in March 2024. The Fed is likely to cut rates by a total of 125 basis points in 2024 and another 125 basis points in 2025.”
For much of the year, the bond market and asset returns were held back by expectations that the Fed would either have to keep interest rates “high for longer” or come back and push up borrowing costs. Now the Treasury market sees a clearer path.
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Mark Dowding, the London-based chief investment officer at RBC BlueBay Asset Management, says he expects yields to rise in the coming weeks after investors “sat on returns” in November.
“After being positive on duration in early November, we took profits on falling yields and moved to a short position over the last week,” Dowding said.
Data this week showed that the core personal consumption expenditures price index, which strips out the volatile food and energy components, rose 3.5% on an annual basis in October. While this Fed's preferred indicator of underlying inflation is moving in the right direction, Dowding says the Fed is unlikely to cut interest rates until they are below 3% – which RBC BlueBay doesn't expect until the second half of the year.
“We think it is premature for the market to run ahead of the Fed,” he said.
Source: Livemint
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