NEW YORK, Sept 17 (Askume) – Bond investors are more cautious and divided over the prospect of a recession in the world’s largest economy, as the Federal Reserve prepares to cut interest rates on Wednesday for the first time in more than four years.
Proponents of the soft landing scenario say recent weak U.S. data do not suggest the economy is falling off a cliff and may not even signal a recession. On the other hand, some die-hard believers cite worrying trends in the job market that could push the economy into a deep recession and force the Federal Reserve to cut interest rates sharply.
Analysts say the Fed is facing an imbalance as it continues on its easing cycle. At the end of its two-day policy meeting starting Tuesday, the Fed is widely expected to lower its benchmark overnight interest rate, which has been in a target range of 5.25%-5.50% since last July.
For months, rate cut forecasts have fluctuated between 50 and 25 basis points (bps). On Monday, U.S. interest rate futures identified a 59% probability of a substantial rate cut of 50 basis points and a 41% probability of a 25 basis point rate cut, according to LSEG calculations. For 2024, the futures market anticipates a rate cut of about 122 basis points by September next year and a reduction of about 250 basis points by 2025.
Former New York Fed President William Dudley called for a 50 basis point rate cut in a Bloomberg News article on Monday, saying rates at the front end of the curve are still well above neutral, and the idea was raised in Singapore last week .
“There’s a disconnect between the bond market and the Fed,” said Byron Anderson, head of fixed income at Laffer Tengler Investments in Scottsdale, Arizona. “The market is certainly more pessimistic than the Fed. But one would be wrong.”
Investors will also keep an eye on the Fed’s quarterly economic forecasts, including interest rate expectations, a so-called “dot plot” that shows how much central bank governors expect to ease. The Fed’s June “dot” corresponds to about 125 basis points of rate cuts in soft landing results in 2024 and 2025.
Although portfolio managers also note the risk of the Fed taking more aggressive steps, these “points” can be removed.
Noah Wise, senior portfolio manager of the fixed income team at Allspring Global Investments Plus, believes that the Fed will be able to achieve a soft landing and expects the neutral interest rate to be no lower than 3%.
“We’ve seen CPI (consumer price index) and PPI (producer price index) data over the last few days largely in line with expectations, ” Wise said. “The data do not support a 50 basis point rate cut in an economic emergency.”
Business soft landing, corporate bonds
Investors say the possibility of a soft landing means reducing the duration of bond portfolios and staying on the front end of the curve. When the rate-cutting cycle coincides with a soft landing, short-term strategies tend to outperform long-term strategies.
Bond investors have been increasing duration, or buying longer-term assets, all year as they prepare for the Federal Reserve’s easing policy and a possible recession. As the economy slows, longer-term notes or bonds tend to outperform other assets.
“It’s time to shorten duration,” said Levertengrad’s Anderson, who is also part of the soft-landing camp. “We will remain short … and taking advantage of the three-month Treasury note, which is still yielding close to 5% … we will remain short.”
Narrowing US corporate credit spreads and Treasury premiums in investment-grade and high-yield markets also pointed to the possibility of a soft landing for many bond investors, analysts said.
On Friday, the ICE Bank of America U.S. Investment Grade Corporate Bond Index (.MERC0A0) showed an option-adjusted spread of just 99 basis points. At the peak of the pandemic in March 2020, the spread reached 382 basis points.
The ICE Bank of America US High Yield Corporate Bond Index (.MERH0A0) also did well, falling 337 basis points on Friday, after hitting 1,009 basis points at the start of the pandemic.
AllspringWise notes that current spreads indicate a small risk premium in corporate credit valuations, evidence that bond investors are not concerned about a US hard landing.
However, Chris Diaz, co-head of fixed income at Brown Advisory in Chicago, believes that although US corporate bonds are “priced correctly”, they represent only a small part of the overall economy.
He believes a 250 basis point rate cut by 2025 is appropriate, citing a deteriorating labor market and that only non-cyclical jobs such as government, health care and education are growing.
“If this trend continues, it won’t be long before we see monthly job losses,” Diaz said.
Diaz said the hard-landing view has been reflected in “bullish” trades that are bullish on shorter-dated Treasuries and bearish on longer-dated Treasuries. During bullishness, long-term Treasury yields are higher than short-term Treasury yields, which is where investors trade when the Fed cuts interest rates.
The widely watched US two- and 10-year yield curves are steepening after more than two years of inversions. On Monday, it hit 10 basis points, the highest level since July 2022.
“The yield curve has steepened quite a bit recently,” Diaz said.
