Bond Market Rallies Depend on How Fast the Fed Cuts Rates

Bond traders who once struggled to forecast how high the Federal Reserve would raise interest rates are now finding the opposite scenario just as challenging—predicting how fast and how much rates will fall. Jamie Patton, co-head of global rates at TCW Group Inc., believes that the market’s expectations of a rate-cutting cycle are too conservative, leaving significant room for short-dated Treasuries to continue rallying. “The Fed will need to cut rates faster and more aggressively than what’s currently priced in by the market,” Patton said.

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However, at JPMorgan Asset Management, Bob Michele has a different outlook. Michele argues that the bond market has already over-anticipated the Fed’s next moves, as the economy remains resilient despite slowing down. As a result, he favors corporate bonds, which offer higher yields, over Treasuries. "I don’t see any major disruptions," Michele said, suggesting that the bond market has gotten ahead of itself.

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These differing perspectives underscore the uncertainty facing investors as the U.S. central bank appears set to lower interest rates for the first time since 2020 at its September 18 meeting. The mere anticipation of this event has already pushed bond prices higher, as traders aim to get ahead of the Fed’s moves. However, there is a risk that the bond market could be caught off guard once again by a post-pandemic economy that has continually surprised both the Federal Reserve and Wall Street analysts with its unexpected strength.

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On Monday, Treasury bonds experienced a decline, with yields rising by up to 5 basis points. This came after the U.S. Labor Department's employment report highlighted ongoing economic uncertainty. Employers added 142,000 jobs in August, falling short of expectations and marking the slowest pace of job growth since mid-2020. Yet, the slowdown wasn’t enough to clarify how quickly or deeply the Fed will ease monetary policy in the coming months.

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Currently, traders are betting that the Federal Reserve will reduce its target interest rate, which is now in the range of 5.25% to 5.5%, by 25 basis points at the upcoming meeting. However, some banks, including Citigroup, are forecasting a larger cut of 50 basis points. By mid-2025, the swaps market is pricing in rates falling to around 3%, a level considered neutral for economic growth.

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Despite the market’s expectations, the Fed’s actions have repeatedly caught traders off guard since the pandemic. Initially, many believed the inflation surge would be short-lived, leading them to underestimate how high interest rates would rise. Later, they prematurely bet that the Fed would reverse its rate hikes, only to suffer losses when the central bank continued to tighten its policy.

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This history of surprises has led some to question whether bond prices have surged too far, too fast. The yield on the two-year Treasury bond, which closely follows the Fed’s key policy rate, has fallen from over 5% in April to around 3.7%, effectively pricing in five quarter-point rate cuts. The resulting lower borrowing costs have also benefited corporate bonds and stock prices, contributing to easier financial conditions without any direct action from the Fed.

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“The Fed needs to cut rates—we all agree on that—but the question is how quickly,” said John Madziyire, senior portfolio manager at Vanguard, which oversees $9.7 trillion in assets. Madziyire’s firm has adopted a “tactical short bias” on bonds, reflecting caution following the recent rally. He added that if the Fed were to cut rates too aggressively, by implementing 50-basis-point reductions, it could loosen financial conditions to the point where inflation might reignite.

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Inflation, however, has been trending in the right direction. The Labor Department is expected to report this Wednesday that the consumer price index (CPI) rose 2.6% year-over-year in August, according to a Bloomberg survey of economists. If accurate, this would represent the smallest inflation increase since 2021. The report will arrive during the Fed’s traditional blackout period, during which officials refrain from public comments ahead of the upcoming Federal Open Market Committee meeting on September 17-18.

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The Federal Reserve’s future policy decisions will hinge on whether the central bank can guide the economy to a soft landing or if it will need to take more drastic action to combat a recession, similar to how it responded during the 2008 financial crisis or after the collapse of the dot-com bubble. As of now, most economists expect the U.S. economy to avoid a recession, a sentiment reflected in stock prices, which remain near record highs despite recent declines.

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For investors, the key question remains: how quickly will the Fed reduce rates, and how deeply will the cuts go? While bond traders are pricing in a gradual easing, others, like Patton, believe the central bank will need to act more aggressively to manage the economy. On the other hand, Michele and those with a more conservative view argue that the bond market has already factored in too many rate cuts, leaving it vulnerable to a stronger-than-expected economy. As the Fed prepares to make its next move, the only certainty is continued uncertainty.

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