Top Economist: US Bond Market Reacts Abnormally to Fed Actions

The following is the view of Mohamed El-Erian, former CEO of Pacific Investment Management Company (Pimco), current President of Queens' College, Cambridge University, and Chief Economic Advisor at Allianz SE. Usually, when the Fed expands the rate cut from 25 basis points to 50 basis points, U.S. bond yields do not soar. However, this has happened. Surprisingly, since September 18, the day of the last Federal Open Market Committee (FOMC) meeting, the 10-year U.S. bond yield has risen by over 60 basis points, covering all major maturities of U.S. bonds. While most analysts agree on the factors behind this unusual development, there is almost no consensus on the ranking of the importance of these factors. This is crucial for our predictions on the future health of the U.S. economy and the sustainability of this year's stock market performance. Fortunately, the next eight days will help clarify this confusing situation. Let's first review the situation before the recent FOMC policy announcement, which was itself quite unusual. The market widely expected a 25 basis point rate cut by the Fed, but this view was suddenly overturned by two articles considered to be strongly influenced by the Fed, hinting that a 50 basis point rate cut might be a more likely outcome. In fact, this "leak" occurred during the Fed's "quiet period," making the situation even stranger. As expected, the Fed subsequently announced a 50 basis point rate cut. The market did not see this rate cut as a more dovish signal in monetary policy, but rather drove the entire yield curve higher. Some analysts even believe that the 10-year U.S. bond yield could further soar above 5%. Four common major reasons have significantly impacted the yield structure changes, affecting many other countries as well: A series of surprising data indicates that the U.S. economy is stronger than consensus forecasts; The "betting market" not only favors a Trump victory but also bets on a 'red wave' (Republican control of Congress), opening the door to imposing significant trade tariffs; Following the September Fed rate decision, including the minutes released in mid-October, signals from Fed officials indicate a policy reversal; Signs show a weakening interest from foreign buyers in U.S. Treasury bonds. While most agree on this series of potential influencing factors, all of these factors lead traders to expect the Fed's eventual rate to be higher and the process to reach that rate to be slower, but there is almost no consensus on their importance. This is crucial for the outlook of the economy and markets. The unique performance of U.S. economic growth and investment will continue to favor the economy. Corporate earnings will also help sustain stock market returns. Looking at recent history, there are signs of another round of shifts in the Fed's forward-looking policy guidance, either neutral or somewhat negative. This largely depends on how much uncertainty it adds and amplifies the volatility in the economy and markets. ** As the Federal Reserve is reducing rather than increasing its holdings of US Treasuries, foreign purchases of US Treasuries are expected to decline. At the same time, the issuance of massive amounts of bonds accounts for 6% of GDP, with no apparent signs of slowing budget deficits, along with significant refinancing needs for both the government and corporations. Many economists are concerned that the most troublesome potential scenario for the economy and the markets is a sudden surge in trade tariffs without corresponding measures to offset the direct inflationary impact. If such tariff increases become a reality, they could lead to higher inflation, particularly affecting low-income households already struggling due to depleted savings from the pandemic and increased credit card balances and other debt burdens. The next eight days will provide analysts with more information to assess the importance of these factors. They will pay particular attention to the monthly employment report, Job Openings and Labor Turnover Survey (JOLTS) data, a series of corporate earnings reports, election results, and the next FOMC meeting. Based on market indicators, almost no one is currently willing to bet heavily on any specific scenario