Is the market too complacent in its bets? Is a "big reckoning" on the horizon?

After experiencing a strong rise in the summer, US bond investors are now facing many challenges, including whether the Fed will cut interest rates quickly, whether inflation will continue to slow down, not to mention the uncertainty of the upcoming US presidential election. The US 10-year Treasury yield fell nearly 30 basis points at the end of August, the largest monthly decline this year, thanks to expectations of faster rate cuts, even though economic data eased concerns of a recession triggered by the previous US non-farm payroll report. With borrowing costs in Germany and the UK dropping significantly in July, bonds in these three regions are poised to see their first quarterly decline since the end of 2023. For some, these actions confirm one of the major investment themes at present - the concept of "bond comeback" in the backdrop of post-pandemic inflation and rising interest rates. Global government bonds yielded only 4% last year, but incurred a loss of 15% in 2021-22, with a year-to-date return of 1.3% this year. However, major investors believe that, optimistically, bonds will lose momentum, and pessimistically, the rally in bonds will be proven to be overdone. Guillaume Rigeade, Co-Head of Fixed Income at Carmignac, said, "We have many indicators showing that the economy is not in recession. We are just experiencing a soft landing, and we believe that the bet on the Fed accelerating into a rate-cutting cycle is unreasonable." Rigeade holds a pessimistic view on long-term bonds on both sides of the Atlantic. US bonds are being driven by bets on Fed rate cuts, with expectations of the Fed cutting rates by about 100 basis points in the remaining three meetings this year, meaning one rate cut could be as much as 50 basis points, and traders are also increasing bets on rate cuts by central banks such as the ECB. However, this bet in the bond market seems to be at odds with the stock market, as the back-and-forth movements in the stock market since mid-July have led to flat returns, while global government bond returns are around 2%. Economists surveyed by foreign media expect that the number of rate cuts by the ECB and the Fed this year will be one less than what traders anticipate. These differences highlight the challenge that investors may find it difficult to obtain meaningful returns in the government bond market for the remainder of 2024. Test Time The first test will be the August US non-farm payroll report to be released next week. Analysts say that if this report shows a significant weakness for the second consecutive month, it could increase bets on a 50 basis point rate cut by the Fed in September, while stronger data could reduce the rate cut magnitude. Guy Stear, Head of Developed Market Strategies at Amundi Investment Institute, Europe's largest asset management company, said, "We are in a phase of economic slowdown... this is when job data fluctuates the most." Inflation easing also supports the bond market. Recently, market measures of US inflation expectations have dropped to the lowest level in over three years, while the Eurozone has dropped to the lowest level in nearly two years Although overall data is approaching the central bank's target, core inflation rates on both sides of the Atlantic remain more sticky and require caution. "The market is too optimistic in pricing in perfect normalization," Rigeade said, adding that the risk of higher-than-expected inflation in the coming quarters is greater. Despite some control, the recent surge in oil prices due to tensions in Libya and the Middle East is a sign of future uncertainty. November Puzzle Undoubtedly, the "elephant in the room" in November is still the U.S. presidential election. The race between current Vice President Harris and Republican opponent Trump is intense, with a Bank of America survey in August showing that 61% of investors have not yet priced in the election in U.S. bonds. "Whoever comes to power will lead to higher fiscal spending and a large supply of U.S. Treasuries," said Flavio Carpenzano, investment director at Capital Group. Carpenzano added that a Trump administration supported by a Republican Congress would put particular pressure on long-term bonds, meaning both spending and inflation would be higher and could potentially remain above the Fed's 2% target. Focus on fiscal discipline and more clarity on U.S. economic growth could support eurozone bonds, which outperformed their U.S. counterparts last year but have lagged behind this year. The U.S. economy grew faster than expected in the second quarter, with economists surveyed by foreign media raising their expectations for full-year U.S. economic growth to 2.5%. They still predict the eurozone to grow by 0.7% this year, with the eurozone's growth in the previous quarter at only 0.3%, and Germany unexpectedly contracting. "There is one economy that needs easing, and that is the eurozone, because the fundamentals of the eurozone are weaker and deteriorating," said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International