The Treasury Market Turns as the Path to Fed Cuts Clears

The world’s largest bond market is approaching a pivotal moment, with US Treasuries recovering their 2024 losses as traders increasingly anticipate three interest-rate cuts this year.

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This week, optimism around declining inflation was evident in US government debt, as yields dropped across the board, reinforcing the case for lower borrowing costs potentially starting as early as September. Notably, two-year Treasury yields, which are more sensitive to Federal Reserve monetary policy than longer maturities, fell by 12 basis points this week to 4.48%, their lowest since March.

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“All signs point to the Fed starting rate cuts in September,” said Sinead Colton Grant, chief investment officer at BNY Mellon Wealth Management. She noted that the market's reaction to the CPI data was bolstered by a weaker June labor market report and Fed Chair Jerome Powell’s recent testimony to US lawmakers.

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Powell reiterated in Washington this week that any rate cuts would depend on a decrease in price pressures, and that policymakers would be monitoring this closely. On Thursday, the June consumer price index data revealed a decline in overall prices, triggering a rally in the bond market.

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Although US producer prices rose slightly more than forecast in June, as per data released on Friday, market participants paid more attention to a drop in consumer sentiment, which led to broadly lower yields.

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These movements have helped the Bloomberg US Treasury Index climb 0.3% this year as of Thursday’s close, recovering from a year-to-date loss of up to 3.4% in April.

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John Madziyire, senior portfolio manager at Vanguard, commented, “Clearly a lot of people missed the yield highs at 4.75%, and there is a bit more FOMO — but also more conviction that the cycle is moving towards lower yields. Now that the Fed is in play, you want to extend longer out the curve.”

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Interest-rate swaps indicated that traders have almost fully priced in a quarter-point rate cut by the September meeting and are expecting more than two reductions this year.

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Some traders are even considering the potential for a half-percentage-point cut in September, buying October federal funds futures contracts at prices that only make sense if more people believe the Fed could start its first easing cycle in years with a significant move.

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Looking ahead, traders are focused on upcoming readings of the Fed’s preferred measure of underlying inflation — the core personal consumption expenditures price index, which excludes volatile food and energy items — and additional information on the job market.

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John Brady, managing director at RJ O’Brien, stated, “The single most important market item in the coming months will be the performance of the labor market. The pace of slowing in the labor market — with the unemployment rate already at 4.1% — is going to dictate policy and will define the ‘soft-landing’ versus ‘hard-landing’ price action in our markets.”

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This optimism for rate cuts is driven by several factors. The recent decline in consumer prices has bolstered the argument for easing monetary policy. Additionally, Powell's remarks suggest a willingness to lower rates if inflation continues to subside. The bond market's reaction, with falling yields and rising prices, indicates that traders are positioning for such a scenario.

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The possibility of a significant rate cut in September is being seriously considered, as traders buy up federal funds futures contracts. This suggests a growing belief that the Fed could start its easing cycle with a substantial reduction. However, the upcoming data on inflation and the job market will be crucial in shaping these expectations.

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In summary, the US Treasury market is at a turning point, with traders increasingly expecting multiple rate cuts this year. This shift is driven by optimism around declining inflation and supportive statements from Fed officials. The bond market's performance, with falling yields and rising prices, reflects this anticipation. Future economic data, particularly on inflation and the labor market, will be key in determining the Fed's course of action and the market's trajectory.

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