Substantial rate cuts inevitable? Recession shadow looms over bond market, traders urgently call on the Fed to rescue the market

Wisdom Investment News App learned that as global markets experience intense volatility, bond traders are betting that the US economy is on the brink of rapid deterioration, prompting the Federal Reserve to start significantly easing monetary policy to prevent an economic recession.

Concerns about rising inflation risks have actually dissipated, replaced by speculation that economic growth is heading towards stagnation unless the central bank begins to lower interest rates from their multi-decade highs.

This has fueled one of the biggest rebounds in the bond market since concerns about a banking crisis erupted in March 2023. The rally has been so strong that the yield on the policy-sensitive two-year US Treasury bonds plummeted by 0.5 percentage points last week to below 3.9%. This rate has remained above the Federal Reserve's benchmark rate (currently around 5.3%) since the global financial crisis or the bursting of the dot-com bubble.

Tracy Chen, portfolio manager at Brandywine Global Investment Management, said, "The market's concern is that the Federal Reserve is lagging behind, and we are transitioning from a soft landing to a hard landing. US Treasuries are a good choice here because I do believe the economy will continue to slow down."

However, it is worth noting that since the end of the COVID-19 pandemic, bond traders have repeatedly misjudged the direction of interest rates, sometimes overbetting. When the economy unexpectedly rebounds or inflation exceeds expectations, they are often caught off guard. At the end of 2023, bond prices also surged as people believed the Federal Reserve was preparing to ease policy, but these gains retreated when the economy continued to show surprisingly strong performance.

Therefore, the recent trend may once again be an excessive fluctuation.

Kevin Flanagan, head of fixed income strategy at WisdomTree, said, "As we saw at the end of last year, the market is overextended and moving too fast. You need more data for validation."

However, after a series of data showed weakness in the job market and a cooling economy sector, market sentiment sharply changed. Last Friday, the US Labor Department reported that only 114,000 new jobs were added in July, far below economists' expectations, and the unemployment rate unexpectedly rose.

Following the Federal Reserve's decision to keep interest rates unchanged on Wednesday, these data points have raised concerns that the Fed is reacting too slowly - similar to the criticism it faced for hiking rates too slowly as the US economy rebounded from the pandemic and inflation surged. Currently, the central banks of Canada and Europe have already begun easing policy, further reinforcing this view.

Last week, concerns about economic slowdown and the Fed's slow response led to a significant sell-off in the US stock market. Over the weekend, market sentiment weakened further after Berkshire Hathaway (BRK.A.US) significantly reduced its stake in Apple (AAPL.US) by nearly 50% in the second quarter Interactive Brokers' Chief Strategist Steve Sosnick said: "In the past 10 days or so, there has been an absolutely huge fluctuation in the two-year US Treasury yield. This makes it difficult for the market to price so-called safe-haven assets, and even more difficult to price high-risk assets such as stocks. From an emotional point of view, Warren Buffett's decision to reduce his holdings in Apple stocks also seems futile."

Betting on a Larger Rate Cut

Against this backdrop, Wall Street economists have begun to predict that the Federal Reserve will take a more aggressive easing stance. Economists at Citigroup and J.P. Morgan expect the Fed to cut rates by 50 basis points at the September and November meetings.

Last Sunday, Goldman Sachs economists raised the likelihood of a US economic recession next year from 15% to 25%, but stated several reasons why there is no need to worry about an economic downturn.

The bank's economists stated that the economy overall is still "good", there are no major financial imbalances, the Fed has significant room to cut rates, and can do so quickly when necessary.

Futures markets indicate that traders have priced in roughly five 25-basis-point rate cuts by the end of this year, suggesting an unusually large 50-basis-point rate cut over the next three meetings. Since the pandemic or credit crisis, the Fed has not taken such a large rate cut measure.

The rebound in the US Treasury market has pushed the yield on the benchmark 10-year Treasury note (a key benchmark for measuring borrowing costs across markets) to around 3.8%, the lowest level since December last year. The stock market's decline, supported by weak earnings reports from companies like Intel (INTC.US) and announcements of layoffs of thousands of employees, has boosted the bond market.

Bloomberg strategist Edward Harrison said: "Locking in yields is clearly the top priority for bond investors, as more evidence of deteriorating employment suggests rate cuts are imminent, and they may come quickly and aggressively in the coming months. Friday's employment report left the bond market hesitant about this framework and exacerbated concerns that the Fed is currently making policy mistakes."

Kathryn Kaminski, Chief Research Strategist and Portfolio Manager at the quantitative fund AlphaSimplex Group, said that given the stock market's weakness and investors rushing to buy bonds before yields fall further, the bond market seems to have room to continue rising. She stated that the company's trend-following signals led them to shift from a bearish to a bullish stance on bonds this month.

"People looking to lock in rates have created significant buying pressure, and risk aversion continues," Kaminski said. "If the Fed cuts rates before the end of this year, the 10-year Treasury yield could drop to near 3%."