Uncertain Fed Rate Cuts Intensify Market Volatility; Investors Turn to Mid-Term Bonds

As the outlook for the Federal Reserve's interest rate cut path becomes more uncertain, bond investors are taking defensive measures. Last week, the release of unexpectedly high inflation data and weak labor market data led traders to reduce bets on the magnitude of the Fed's rate cuts for the remainder of 2024, also pushing U.S. Treasury yields to their highest levels since July. Additionally, a closely watched measure of expected volatility in U.S. Treasuries rose to its highest level since January.

Against this backdrop, it has become challenging for investors to decide where to allocate cash in the world's largest bond market. To mitigate vulnerabilities stemming from economic resilience, potential fiscal shocks, or turbulence in the U.S. elections, asset management giants including BlackRock, PIMCO, and UBS Global Wealth Management advocate purchasing five-year bonds, as they are less sensitive to such risks compared to short-term or long-term bonds.

Solita Marcelli, Chief Investment Officer for the Americas at UBS Global Wealth Management, suggests investing in medium-term bonds, such as five-year U.S. Treasuries and investment-grade corporate bonds. She stated, "We continue to advise investors to prepare for a low-interest-rate environment by investing excess cash, money market assets, and maturing term deposits into assets that can provide more enduring income."

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Bond traders are currently betting that the Federal Reserve will cumulatively cut rates by 45 basis points in the next two policy meetings, lower than the 50 basis points wagered before the September non-farm employment report was announced. Meanwhile, options trading bets on one more rate cut this year, and a more complex options trade bets on an additional 25 basis points cut this year, followed by a pause in rate cuts early next year.

In the coming weeks, the market still has significant room for volatility, and this is not just related to the U.S. elections—which will determine investors' expectations for U.S. fiscal policy. The ICE BofA Move Index—a volatility indicator tracking option-based expected yield volatility—is just a stone's throw away from its 2024 high, indicating that investors anticipate the turmoil will not subside.

As investors await the U.S. Treasury's announcement of quarterly note and bond sales, next month's employment report, and the Federal Reserve's interest rate decision on November 7th, interest rate volatility could persist for weeks. Citadel Securities warns clients to prepare for "significant future volatility" in the bond market. The firm expects the Federal Reserve to cut rates by another 25 basis points in 2024.

Investors anticipate that the Federal Reserve will further ease rate constraints in the coming months to ensure a soft economic landing. David Rogal, a portfolio manager in BlackRock's fundamental fixed income department, stated, "As the election enters the option value window, implied volatility will rise." The firm prefers medium-term U.S. Treasuries, as it believes that as long as inflation cools, the Federal Reserve will implement a "repricing cycle," adjusting policy rates from 5% to a range between 3.5% and 4%.

Concerns among investors about the U.S.'s rising deficit causing trouble for long-term U.S. Treasuries will help establish the "sweet spot" status for five-year U.S. Treasuries. Anmol Sinha, head of the $91.4 billion bond fund at Capital Group, said, "The shorter end of the yield curve, that is, the five-year and more, currently seems more attractive to us." He added that their positions would benefit from "a more pronounced slowdown in growth, economic recession, or negative shocks," or alternatively, in a context where the risk premium for long-term bonds is not significant, concerns about increasing fiscal deficits and the upcoming supply of Treasury bonds intensify.

Nevertheless, with the yield on the ten-year U.S. Treasury note approaching 4.1%, the sell-off following the employment data has also pushed the ten-year U.S. Treasury into the "buy zone" for some long-term investors. Roger Hallam, head of global rates at Vanguard, said, "Our core view is that the economy will indeed slow down next year because the Federal Reserve's policy will remain restrictive. This means that when the yield on the ten-year U.S. Treasury note is above 4%, there is an opportunity to start extending the duration of our portfolio, considering the impulse of this downward growth next year." He added that this would allow the firm to slowly shift towards a more bond-positive position.

It is reported that since around early September, Vanguard has also benefited from a tactical short position on U.S. Treasuries as yields began to rise. The firm is still engaged in this short-term trade, although the scale has been reduced from its initial level.