Bond Market Under Pressure
By Althea Spinozzi, Head of Fixed Income Strategy at Saxo
The Federal Reserve is expected to cut the Fed funds rate by 25 basis points at the November 7 meeting. This aligns with market expectations and follows a weaker-than-expected nonfarm payroll report.
The Fed is likely to continue its measured approach, emphasizing gradual rate cuts rather than drastic policy shifts. Chair Jerome Powell is expected to highlight a data-dependent and restrained policy stance.
US inflation data shows signs of easing in some areas but remains stubborn in key sectors like shelter and services. The growth and the labor market continue to demonstrate resilience, adding to the complexity of the economic outlook. The November 5 presidential election adds a layer of uncertainty. Powell is anticipated to emphasize the Fed’s independence but may face questions about how political events, such as the steepening of the yield curve, could influence monetary policy.
Surging Real Rates Threaten Fed's Easing Plans and Fuel Volatility
The bond market is facing pressure as real interest rates have climbed significantly. The 10-year TIPS-implied real yield, for example, has surpassed 2% for the first time since July, indicating tighter financial conditions. If the Fed sees this increase in real rates as a threat to the economy, it may suggest that the current policy easing has not been sufficient. In that case, the Fed could consider signalling more aggressive rate cuts or adjusting quantitative tightening measures to boost liquidity and reduce borrowing costs.
However, if the Federal Reserve does not directly address concerns about financial conditions, market volatility could remain elevated. The bond market will be closely monitoring how long-term yields react if the Fed continues with its strategy of 25-basis-point rate cuts. This is especially critical given mounting concerns about political uncertainty, fiscal deficits, and large Treasury issuance. These factors increase the risk of a "bear steepening" scenario, where long-term yields rise while short-term yields fall, emphasizing the complex relationship between Fed policy and market expectations, particularly regarding inflation and economic growth.
Short-term yields, such as the 2-year Treasury, are likely to decline as markets anticipate easier monetary policy. However, long-term yields, like the 10-year Treasury, may remain high or even increase, since they depend not only on Fed decisions but also on expectations for future growth and inflation. For example, if investors believe future government policies will drive up inflation, this could accelerate the sell-off of long-term bonds, as their value is expected to decrease in real terms. Meanwhile, short-term rates would likely drop in line with the Fed's gradual approach to rate cuts.
Navigating Rising Real Rates, Inflation, and Market Volatility
The upcoming FOMC meeting has significant implications for investors, especially in the face of persistent inflation, rising real rates, and economic resilience. If the Fed maintains its current rate cut strategy without addressing broader financial concerns, market volatility could stay elevated. To preserve value and hedge against this uncertainty, investors may consider focusing on shorter-duration bonds and inflation-protected securities like TIPS to mitigate the impact of rising yields. In equities, prioritizing defensive sectors, dividend-paying stocks, and a well-diversified portfolio can help manage risk. Commodities, such as gold, may serve as an inflation hedge, while maintaining cash or cash equivalents can offer liquidity and stability. Hedging and global diversification also remain crucial strategies to shelter from potential shocks in a market heavily influenced by monetary policy and political uncertainty.
Further reading : click here
