No Signs of Imminent Recession: Why Bond Investors Should Approach Insurance Rate Cuts with Caution No Signs of Imminent Recession: Why Bond Investors Should Approach Insurance Rate Cuts with Caution No Signs of Imminent Recession: Why Bond Investors Should Approach Insurance Rate Cuts with Caution

No Signs of Imminent Recession: Why Bond Investors Should Approach Insurance Rate Cuts with Caution

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • No signs of an upcoming recession: The macroeconomic backdrop, characterized by a cooling labor market, resilient consumer spending, and persistent inflation, does not align with the notion of aggressive interest rate cuts. Recent data, including strong retail sales, challenge the expectation of significant rate cuts by year-end.
  • The Federal Reserve might be preparing to cut rates in September: Recent speeches by FOMC members, including Bostic, Bowman, Daly, and Powell, suggest that a rate cut may be on the table for September.
  • Rate cuts may not lower long-term yields: An insurance rate cut by the Fed may not lead to lower long-term yields, as the long-term equilibrium Fed Funds rate could continue to rise. This creates a "floor" for the long end of the yield curve, meaning that long-term yields might not decline as expected, and could even rise, especially if markets demand a higher risk premium for holding long-term bonds.
  • Caution in bond market duration: Given the potential for economic acceleration and the rising long-term equilibrium Fed Funds rate, it's crucial for investors to be selective with bond maturities.

No imminent recession, but a Fed insurance rate cut may still be on the horizon: implications for bond markets

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.

The macroeconomic backdrop suggests that an imminent recession is unlikely.

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?

  • Consumers continue to spend. The latest retail sales report shows growth in ten out of thirteen categories, with declines only in clothing, miscellaneous store retailers, and sporting and hobby goods. This trend is supported by the University of Michigan Consumer Sentiment Survey, which has recorded rising consumer confidence since June 2022. While there are indicators of economic uncertainty—such as more selective spending habits noted in Walmart’s recent earnings report and a cooling of post-pandemic travel—it’s clear that a recession is not around the corner.
  • Inflation remains a significant concern, with the NFIB survey this week indicating it as the top issue for 26% of small businesses. A notable 24% of these businesses plan to increase prices in the next three months, signaling continued inflationary pressures. The St. Louis Fed’s Price Pressures Measure suggests a 97% probability that inflation will exceed 2.5% over the next year.
  • Despite rising unemployment, a recession seems unlikely. The current unemployment rate of 4.3% is slightly higher than recent historical lows but remains below the long-term average of 5%. The increase is primarily among reentrants and those on temporary layoffs, rather than permanent job losers. This stability in permanent job loss suggests the labor market is resilient. Additionally, wages are growing at 3.6%, above the historical average, further supporting consumer spending and economic stability.

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.

Recent FOMC speeches signal potential September rate cut

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.

Other recent Fixed Income articles:

14-Aug Markets Skeptical Despite Positive UK Inflation Report
09-Aug Yield Curve is Disinverting: Lessons from Past Crises
07-Aug Stable Bond Spreads and Robust Issuance Make a 50 bps Rate Cut in September Unlikely
06-Aug Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview.
05-Aug Why Investors Must Pay Attention: BOJ’s Hawkish Moves Could Roil Global Markets
30-July BOE Preview: Better Safe than Sorry
29-July FOMC Preview: A Data-Dependent and Balanced Approach
24-July Market Impact of Democratic vs. Republican Wins
23-July Insights into this week's US Treasury auctions: 2-, 5-, and 7-year overview.
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
15-July Understanding the "Trump Trade"
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?
01-Mar The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.
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.

Quarterly Outlook 2024 Q3

Sandcastle economics

01 / 05

  • Macro: Sandcastle economics

    Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.

    Read article
  • Bonds: What to do until inflation stabilises

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain inflation and evolving monetary policies.

    Read article
  • Equities: Are we blowing bubbles again

    Explore key trends and opportunities in European equities and electrification theme as market dynamics echo 2021's rally.

    Read article
  • FX: Risk-on currencies to surge against havens

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperform in Q3 2024.

    Read article
  • Commodities: Energy and grains in focus as metals pause

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities in Q3 2024.

    Read article
Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo or its affiliates.

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK Limited (“Saxo”) is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo holds a Type 1 Regulated Activity (Dealing in Securities); Type 2 Regulated Activity (Dealing in Futures Contract); Type 3 Regulated Activity (Leveraged Foreign Exchange Trading); Type 4 Regulated Activity (Advising on Securities) and Type 9 Regulated Activity (Asset Management) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products may result in your losses exceeding your initial deposits. Saxo does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo does not take into account an individual’s needs, objectives or financial situation. Please click here to view the relevant risk disclosure statements.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-hk/about-us/awards.

The information or the products and services referred to on this site may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and services offered on this website are not directed at, or intended for distribution to or use by, any person or entity residing in the United States and Japan. Please click here to view our full disclaimer.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc. Android is a trademark of Google Inc.