Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Head of Fixed Income Strategy
Recent U.S. economic data and insights from FOMC members suggest that we may be heading toward an "insurance" Fed rate cut in September, even as the economy remains fundamentally strong. An "insurance" rate cut occurs when the Federal Reserve lowers interest rates preemptively—not in response to a recession, but as a safeguard against potential economic slowdowns or emerging risks. The goal is to "insure" the economy, promoting borrowing, investment, and spending to maintain growth and guide the economy toward a soft landing.
While such a move could be favorable for stock markets, the impact on bond markets may be more complex. Typically, falling inflation combined with interest rate cuts boosts sovereign bond prices. However, this time, investors may need to be more selective about which maturities they choose, as there is a risk of economic acceleration that could affect long-term yields (to learn more about it click here).
One key consideration is the long-term equilibrium Fed Funds rate, which could rise even as the Fed cuts rates in the short term. This would create a "floor" for the long end of the yield curve, meaning longer-term bond yields might not fall as much as some investors expect. The reason for a potential increase in the long-term Fed Funds rate is the current strength of the economy, which may be operating at a higher equilibrium level than in the past.
The long-term neutral Fed Funds rate remained stable at 2.5% from June 2019 until March of this year, when it began to rise, currently standing at 2.75%. If the Fed were to lower rates to 2.75% in the coming years, the 10-year U.S. Treasury yield would likely stabilize at around 100-150 basis point premium over the Fed Funds rate as the yield curve normalizes. This would imply a fair value for the 10-year Treasury between 3.75% and 4.25%. If the neutral rate continues to increase, the fair value for the 10-year Treasury would rise accordingly.
This scenario suggests that while the front end of the yield curve, driven by monetary policy expectations, may shift lower, the long end could rise sharply, leading to the much-feared bear steepening of the yield curve. Bear steepening occurs when long-term bond yields climb faster than short-term yields, causing the curve to steepen. In this case, I would anticipate short-term yields to drop as the Fed cuts rates, while long-term yields increase as markets demand a higher risk premium for holding longer-term bonds. This shift is typically viewed unfavorably by markets, as a significant portion of the economy’s debt is tied to long-term interest rates.
After more than a week of market expectations leaning heavily towards an impending recession, U.S. economic data released on Thursday challenged that narrative. U.S. retail sales excluding food rose by 2.6% over the past year, while continuing claims surprised on the downside over the last two weeks, indicating that consumers continue to spend and the job market remains resilient, despite the uptick in the July unemployment rate.
What can we say about the current state of the economy?
Given these conditions, the expectation of substantial interest rate cuts (up to 100bps) by year-end appears overly optimistic. Persistent inflation and robust economic activity suggest that the Federal Reserve may not be able to deliver the expected rate cuts. As a result, markets have adjusted their expectations, reducing the likelihood of a 40 basis point rate cut in September to 33 basis points and lowering the probability of four rate cuts by the end of the year.
FOMC members’ speeches following the July FOMC meeting have clearly indicated that an interest rate cut might be coming in September. Bostic, Bowman, Daly and Powell are voting committee members that have expressed the openness to an upcoming rate cut.
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06-Aug Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview.
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30-July BOE Preview: Better Safe than Sorry
29-July FOMC Preview: A Data-Dependent and Balanced Approach
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16-July Insights into this week's US Treasury auctions: 20-year U.S. Treasury bonds and 10-year TIPS.
15-July ECB Preview: Conflicting Narratives – Rate Cuts vs. Data Dependency
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11- July Bond Update: Faster Disinflation Paves the Way for Imminent Rate Cuts, but Risks of Economic Reacceleration Remain
09-July Insights into This Week's U.S. Treasury Auctions: 3-, 10-, and 30-Year Tenor Overview and Market Dynamics.
08-July Surprise Shift in French Election Fails to Rattle Markets for Good Reasons.
04-July Market Optimism Ahead of French Elections Drives Strong Demand for Long-Term Bonds
01-July UK Election Uncertainty and Yield curve Dynamics: Why Short-Term Bonds Are the Better Bet
28-June Bond Market Update: Market Awaits First Round of French Election Voting.
26-JuneBond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes.
30-May ECB preview: One alone is like none at all.
28-May Insights into this week's US Treasury auctions: 2-, 5-, and 7-year tenors overview.
22-May UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path.
17-May Strong trade-weighted EUR gives ECB green light to cut rates, but bond bull rally unlikely
14-May UK labor data and Huw Pill's comments are not enough for a bond bull rally
08-May Bank of England preview: Rate cuts in mind, but patience required.
06-May Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview
02-May FOMC Meeting Takeaways: Why Inflation Risk Might Come to Bite the Fed
30-Apr FOMC preview: challenging the March dot plot.
29-Apr Bond Markets: the week ahead
25-Apr A tactical guide to the upcoming quarterly refunding announcement for bond and stock markets
22-Apr Analyzing market impacts: insights into the upcoming 5-year and 7-year US Treasury auctions.
18-Apr Italian BTPs are more attractive than German Schatz in today's macroeconomic context
16-Apr QT Tapering Looms Despite Macroeconomic Conditions: Fear of Liquidity Squeeze Drives Policy
08-Apr ECB preview: data-driven until June, Fed-dependent thereafter.
03-Apr Fixed income: Keep calm, seize the moment.
21-Mar FOMC bond takeaway: beware of ultra-long duration.
18-Mar Bank of England Preview: slight dovish shift in the MPC amid disinflationary trends.
18-Mar FOMC Preview: dot plot and quantitative tightening in focus.
12-Mar US Treasury auctions on the back of the US CPI might offer critical insights to investors.
07-Mar The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.
05-Mar "Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?
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29-Feb ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.