As market traders brace for the Federal Reserve's first rate cut since 2020, the U.S. Treasury market is poised for its strongest performance in three years.
According to data from the Bloomberg U.S. Treasury Total Return Index, the index has posted a 1.7% return this month as of August 28, marking the fourth consecutive month of gains. The index has been rising since the end of April, driven by increased expectations of lower future U.S. borrowing costs, with a year-to-date increase of more than 3%.
After facing some pressure earlier this year, the recent rebound in the Treasury market has been quite pronounced. This is largely attributed to signs of cooling inflation and a softening labor market in U.S. macroeconomic data, which have increased the likelihood that the Federal Reserve will lower rates from their highest levels in over two decades this fall.
Earlier this month, the U.S. non-farm payroll report unexpectedly showed the unemployment rate rising to 4.3%, causing the yield on the 10-year Treasury note to briefly touch a 14-month low of 3.67%. As of Thursday's close in New York, the 10-year Treasury yield was trading around 3.86%.
Tiffany Wilding, an economist at Pacific Investment Management Company (PIMCO), stated that despite the recent rebound, the bond market remains attractive and there is potential for further gains.
Last week, Fed Chair Jerome Powell indicated at the Jackson Hole Global Central Banking Symposium that the time for policy adjustments has come, suggesting that the Federal Reserve may end its two-year fight against inflation. Since July 2023, the Fed has maintained its benchmark interest rate at a high of 5.25% to 5.5%.
Bond traders anticipate that the Fed will cut rates by about 100 basis points this year, which means there could be gradual rate reductions over the three policy meetings left this year, including a significant 50 basis points cut.
Given that short-term bonds are more sensitive to policy changes, their performance in August has been particularly strong. A key part of the yield curve is nearing positive for the first time since July 2022—the spread between the 2-year and 10-year Treasury yields has narrowed to less than 2 basis points. In March 2023, this spread exceeded 100 basis points, marking the largest inversion since 1981.
However, the continued rise in bond prices has also raised concerns about whether the market has climbed too high. Looking ahead, the main risk for the bond market lies in the trends within the U.S. labor market. If the labor market stabilizes, the pace of the Fed's rate cuts might be slower than the market expects.
Data released on Thursday, including the revised GDP figures for the second quarter and initial jobless claims, showed that the U.S. economy remains resilient, leading to a drop in Treasury prices and an increase in yields.
Meghan Swiber, a rate strategist at Bank of America, noted that the rapid shift in market sentiment is surprising, but the existing data is insufficient to fully support the market's expectation of swift and significant rate cuts by the Fed this year.
Additionally, investors should pay attention to the July PCE price index to be released at 8:30 PM tonight, which is the Fed's most-watched inflation gauge. Economists generally forecast a 0.2% month-over-month increase and a 2.6% year-over-year increase in the overall PCE price index for July; the core PCE index is expected to rise by 0.2% month-over-month and 2.7% year-over-year.
These forecasts are slightly higher than the data from June. Analysts at Bank of America believe that the actual data may match expectations and attribute the slight increase in inflation year-over-year to base effects. Overall, the PCE data may reinforce the Fed's confidence to ease policy in September.
Atlanta Fed President Raphael Bostic stated on Thursday that while U.S. inflation has significantly fallen from its 2022 highs, it still remains far from the central bank's 2% target. He emphasized that he is closely monitoring short-term data and prefers to wait for more data to confirm economic trends rather than rushing to cut rates.
