(Bloomberg) -- The bond market has ended its long flirtation with the Federal Reserve cutting interest rates by half a point this month as resilient inflation and labor market data reinforce a measured course of action.
Swap traders have fully priced in a quarter-point reduction at the Fed’s policy announcement next week. The Treasury market ended lower Wednesday after a choppy session that started with a selloff in the wake of inflation data. The S&P 500 Index rebounded to close 1.1% higher after a volatile trading day. Stocks closely tied to the economy, including equipment rental companies and debt-heavy small caps, were among the most hit in trading before closing higher.
“Both the bond market and the Fed need to see where the economy lands,” said George Catrambone, head of fixed income, DWS Americas.
Whether the economy is entering a soft landing that only requires a series of modest rate cuts, as seen in 2019 and 1995, or heading for a harder landing at some stage in the next year is the biggest conundrum for investors.
The policy-sensitive two-year yield initially rose as much as 9.5 basis points to 3.69%, with the 10-year note backing up 4 basis points to 3.68%. At the end of the session the front end remained higher by about 5 basis points.
“A point of pain is the front end as the market has priced in so many cuts,” said Catrambone.
The central bank has held rates from 5.25% to 5.5% since July 2023, and as inflation pressure moderated during the past 14 months, that policy setting has become increasingly restrictive. This trend spurred Fed officials in recent weeks to set the stage for an easing cycle to start this month.
“The Fed’s going to start cutting, and we’ll see 25 basis points in September,” said Matt Eagan, portfolio manager and head of the Full Discretion team at Loomis Sayles.
Once the Fed begins lowering borrowing costs, the debate will center around the pace of subsequent easing. Fed officials have identified a softening in the labor market as the spark that would spur faster easing in the coming months. But a string of weaker-than-expected employment reports did not build a case for rapid cuts.
Eagen expects a shallow rate-cutting cycle that results in the Fed easing toward 3.5%, not current market expectations of less than 3%, as Loomis expects inflation pressure holds up due to “structural tailwinds” that includes “predominantly the deficit, an aging population, and security concerns around geopolitics.”
For traders, the tail risk for the market over the coming months is the performance of the economy and the jobs sector. Two monthly employment reports are due before the Fed announces its Nov. 7 meeting outcome just a couple of days after US elections.
Currently, Fed swaps are pricing in over 140 basis points of rate cuts by the Jan. 29 rate decision, equivalent to roughly two half-point moves over the next four gatherings barring no intra-meeting event.
What Bloomberg market strategists are saying
“If the Fed fails to validate market pricing next week with its dot plot of future policy rates, yields should rise, capped only by the hopes and dreams of future 50-bps rate cuts on upcoming labor market weakness.”
Edward Harrison, MLIV Macro Strategist
In terms of market vulnerability, the two-year yield is likely to shift higher should the Fed deliver a measured pace of rate cuts that falls short of the 250 basis points of easing priced by futures contracts for September 2025.
Investor appetite for bonds at current yields was illustrated by solid demand for a sale of $39 billion 10-year notes at 1 p.m. in New York.
“We were never in the 50 basis point camp, and it seems like the modest upside surprise in CPI would likely be enough to give any policymakers considering a bigger move pause,” said Zachary Griffiths, head of US investment grade and macro strategy at CreditSights.
On Wednesday, following the CPI data, Citi economists ditched their forecast for a half-point rate cut at next week’s Fed meeting, while maintaining their call for a total of 125 basis points of easing this year. JPMorgan Chase & Co. remains a holdout sticking with its bet that the Fed would slash rates by a half-percentage point this month.
“The Fed got lucky that the CPI data bailed them out. I suspect that fed funds futures will recede sufficiently now that the FOMC need not intervene to massage expectations going into the meeting,” said Stephen Stanley, the chief US economist at Santander Capital Markets.
Last month’s highly anticipated Jackson Hole economic symposium and subsequent Fed speak provided little guidance on the central bank’s policy path for the rest of the year, he added.
“Inflation has now cooled to room temperature, there is really not a significant inflation problem,” David Kelly, chief global strategist at JPMorgan Asset Management, told Bloomberg Television after the CPI report was released.
The report “does not call for drastic Fed action and I would be happy to see 25 basis points next week,” Kelly said.
--With assistance from Liz Capo McCormick and Norah Mulinda.
(Updates market moves in 2nd and 5th paragraphs.)