The Fed's interest rate cut clouds the sky, traders prepare to deal with "major fluctuations"

As the outlook for the Fed's interest rate cuts becomes more uncertain, bond investors are starting to take defensive measures. Last week, high inflation and soft labor market data led traders to reduce their bets on the Fed's 2024 easing, pushing yields to their highest level since July. At the same time, a closely watched measure of expected volatility in U.S. Treasuries rose to its highest level since January. In this context, investors find it difficult to decide where to deploy cash in the world's largest bond market. To mitigate vulnerabilities to economic recovery, potential fiscal shocks, or turmoil from the U.S. election, asset management giants including BlackRock, Pacific Investment Management Company, and UBS Global Wealth Management advocate buying five-year bonds, as bonds of this maturity are less sensitive to such risks than short-term or long-term bonds. At UBS Global, Solita Marcelli recommends investing in medium-term bonds, such as around five-year U.S. Treasuries and investment-grade corporate securities. The company's Americas chief investment officer stated, "We continue to advise investors to prepare for a low-rate environment by allocating excess cash, money market assets, and maturing time deposits to assets that can provide more sustainable income." Last week, due to an unexpected jump in weekly jobless claims, which overshadowed slightly hot U.S. consumer price readings, the bond market was impacted, and Marcelli's preferred yield curve segment underperformed. The impact on the bond market is that traders' bets on rate cuts have converged, with the expected easing of the next two Fed meetings totaling only 45 basis points, and a further 50 basis point cut before the September employment report is seen as a certainty. Meanwhile, the target of options flow is another rate cut this year. A more complex options trading target is a 25 basis point cut this year, followed by a pause in the easing cycle early next year. In the coming weeks, there is still significant volatility in the market, not only related to the U.S. election, which will determine investors' expectations for U.S. fiscal policy. The ICE BofA Move Index, which tracks volatility expectations based on option-implied yield movements, is not far from its 2024 high, indicating that investors' expectations of turmoil have hardly eased. Due to investors awaiting the Treasury's quarterly bill and bond issuance (expected to remain stable), the next monthly employment report, and the Fed's policy decision on November 7, interest rate volatility could persist for several weeks. Citadel Securities warns clients to prepare for "significant future volatility" in the bond market. The company expects the Fed to cut rates by 25 basis points again in 2024 David Rogal, the portfolio manager of the fixed income department at BlackRock, said, "As the election enters the window of option value, implied volatility will rise." The company prefers mid-term US Treasuries because it believes that as long as inflation cools down, the Federal Reserve will pursue a "rebalancing cycle," lowering interest rates from 5% to "between 3.5% and 4%." The increase in the US fiscal deficit will pose troubles for longer-term US Treasuries, and this concern helps establish the dominant position of the five-year government bonds. "The shorter part of the yield curve, namely the five-year or shorter part, currently seems more attractive to us," said Anmol Sinha, the investment director of the $91.4 billion US bond fund under Capital Group. Sinha mentioned that their positions will benefit from "more pronounced growth slowdown, economic recession, or negative shocks." Another scenario is the intensification of concerns about increasing fiscal deficits and upcoming government bond supply, as the risk premium for long-term bonds is not significant. However, with the 10-year US Treasury yield approaching 4.1% and a significant drop after the non-farm payroll report, this benchmark is also being pushed into a "buying zone" for some long-term investors. Roger Hallam, Global Head of Rates at Vanguard, said in an interview, "Our core view is that due to the restrictive nature of the Fed's policy, the economy will indeed slow down next year." For the company, this means that when the 10-year US Treasury yield exceeds 4%, "we will have the opportunity to start extending the duration of the portfolio to cope with the downward pressure on economic growth next year." He added that this will gradually lead the company to "overweight bonds." Starting from early September, as US Treasury yields began to rise, Vanguard also benefited from tactical short positions in US Treasuries. The company is still engaging in these short-term trades, but the scale has been reduced from the initial level