European investors are eyeing the rapid price shifts in the US bond market, driven by expectations of interest rate cuts. While the rise in US government bond prices has been enticing, seasoned investors are now questioning how long this rally can last.
Predicting the path of US interest rates has proved challenging. Just as many underestimated the persistence of inflation and the extent of rate hikes, there’s now uncertainty around the pace and timing of the Federal Reserve’s potential cuts. Investors who bought into the bond market too early were left disappointed, as their anticipated returns failed to materialise. Now, latecomers may face a reverse risk.
Laurent Denize, chief investment officer at Oddo BHF, sounds a cautious note: “There is a real risk that the recent rally in government bonds could reverse. It may be wise to take profits now and wait for better entry points.”
However, some market participants still see room for gains. Gregory Peters, co-CIO at PGIM, is among those betting on further drops in long-term yields. “As long as the market anticipates Fed rate cuts, this gives investors a short window to extend portfolio duration and lock in higher yields,” he argues, calling the current market environment an “attractive entry point.”
This divergence of opinion underscores the dilemma facing bond investors. While the Federal Reserve is widely expected to cut rates this month at its 18 September FOMC meeting, it’s far from certain that bondholders will benefit as much as they hope.
In recent weeks, US two-year government bond yields have fallen 35 basis points to 3.65 percent, while 10-year yields have declined 14 basis points to 3.69 percent. Yet, the market remains jittery, driven by mixed economic signals, particularly from the US labour market, where data has been subject to frequent revisions.
Labour market data fuels volatility
Recent market moves were sparked by weaker-than-expected US job growth. In August, the US added 118,000 new jobs, falling short of economists’ projections of 140,000. Despite the underwhelming figures, the subsequent fall in interest rates appeared to some as an exaggerated response.
Ronald Temple, chief strategist at Lazard Asset Management, cautions against overreacting: “We’ve become accustomed to a robust economy and tight labour market, so any slowdown tends to trigger negative market reactions, with fears shifting from inflation risks to concerns about a potential recession.”
Temple advises bond investors to be cautious. “As long as job growth remains above 100,000 per month, fears of a recession are premature,” he notes. However, he adds that long-term US government bonds could become less appealing if interest rates don’t decline further, or worse, if they begin to rise again.
“My base case is that the Fed’s rate-cutting cycle ends at around 3.5 percent,” Temple predicts. “If that holds, fair value for the US 10-year bond could be closer to 4 percent. The market may already be too aggressive in pricing in rate cuts.”
If a recession does materialise, Temple foresees the Fed cutting rates to 2.5 percent, which could push 10-year yields down to 3.25 percent. However, he warns that such a scenario remains speculative and advises against betting on it. Instead, Temple recommends focusing on short- to medium-term bonds, which currently offer better yields. “I prefer the two- to five-year part of the curve over the 10-year.”
Fed rate cuts: How many, how soon?
The market currently expects the Federal Reserve, with its target range between 5.25 percent and 5.5 percent, to begin cutting rates by 25 basis points, possibly as soon as September. By mid-2025, markets are pricing in a Fed funds rate of around 3 percent, a level widely considered neutral for sustainable economic growth.
The key question remains: How deep will these cuts go? According to the CME FedWatch Tool, there’s a 75 percent probability of a 25-basis-point cut this month and a 25 percent chance of a larger 50-basis-point reduction.
Christian Scherrmann, US economist at DWS, anticipates a measured approach from the Fed, starting with a 25-basis-point cut. “The economy is slowing but not collapsing, and a soft landing remains the most likely outcome,” he says.
Similarly, Mark Dowding, chief investment officer at BlueBay Asset Management, sees little chance of a recession in the near term. “With the unemployment rate currently at 4.2 percent, the likelihood of a 50-basis-point cut on 18 September remains slim,” Dowding notes.
For investors, the opportunity to capitalise on US rate cuts may still exist—but the window is narrowing, and the risks are mounting.
Fed target rate probabilities for 18 Sept. FOMC meeting
Source: CME FedWatch.
This article originally appeared in Dutch on InvestmentOfficer.nl.