Volatile Bond Market Puts Traders on Defense Amid Fed-Cut Doubts

(Bloomberg) — Bond investors are going on defense as the outlook for the Federal Reserve’s interest-rate cutting path turns more uncertain.

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The combination of sticky inflation and weak labor-market figures last week led traders to trim bets on the degree of Fed easing left in 2024, while also driving yields to the highest since July. Meanwhile, a closely watched measure of expected volatility in Treasuries rose to the highest since January.

It’s a backdrop that’s making it hard to decide where to deploy cash in the world’s biggest bond market. To lessen the vulnerability to a resilient economy, potential fiscal shocks or turbulence around US elections, asset managers including giants like BlackRock Inc., Pacific Investment Management Co. and UBS Global Wealth Management advocate for buying five-year debt because the maturity is less sensitive to such risks than its shorter or longer counterparts.

At UBS Global, Solita Marcelli suggests investments with medium-term duration, such as Treasuries and investment-grade corporate securities with about a five-year maturity.

“We continue to recommend investors position for a lower-rate environment, deploying excess cash, money-market holdings, and expiring fixed-term deposits into assets that can offer more durable income,” said the firm’s chief investment officer for the Americas.

Marcelli’s preferred part of the yield curve outperformed last week as the bond market was whipsawed by an unexpected jump in weekly jobless claims that outweighed a slightly hotter read for US consumer prices.

The upshot for the bond market is that traders have tempered their rate-cut bets, with just 45 basis points of easing priced in for the next two Fed meetings, whereas a full half-point of cuts was seen as a lock prior to the September jobs report. Options flows, meanwhile, have targeted just one more additional cut this year. A more complicated options trade targets one quarter-point reduction for this year followed by a pause in the easing cycle early next year.

There’s plenty of scope for further gyrations in the weeks ahead, and it’s not just about the US election, which will be decisive in setting investors’ expectations for the US fiscal path. The ICE BofA Move Index — a gauge of volatility that tracks anticipated swings in yields based on options — isn’t far from its 2024 high, showing investors expect little relief from the turbulence.

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Elevated rates volatility is likely to persist for weeks to come as investors await the Treasury’s quarterly announcement for note and bond sales, which is expected to remain steady, the next monthly jobs report and the Fed’s Nov. 7 policy decision.

Citadel Securities is warning clients to brace for what they dub “material volatility going forward” in bond markets. The firm expects the Fed to cut once more in 2024, by a quarter-point.

Investors anticipate further easing as they expect the central bank to move to less restrictive rates over the coming months to secure a soft landing for the economy.

“As the election rolls into the window for option values, implied volatility will look higher,” said David Rogal, a portfolio manager in the fundamental fixed-income group at BlackRock. The firm prefers intermediate-dated Treasuries because it sees the Fed pursuing “a recalibration cycle” from 5% to “getting policy between 3.5% and 4%,” as long as inflation is cooling.

Helping to establish the five-year note as a sweet spot is the concern that a rising US deficit spells trouble for longer-dated Treasuries.

“The shorter maturity part of the yield curve, five years and less, looks more compelling to us at the moment,” said Anmol Sinha, investment director for Capital Group’s $91.4 billion Bond Fund of America.

Sinha said their positioning would benefit from “a more pronounced growth slowdown or a recession or a negative shock. The other scenario is rising concerns about higher fiscal deficits and impending Treasury supply, as there is not much risk premium in long-dated bonds.”

‘Buy Zone’

Still, with 10-year yields near 4.1%, the post-payrolls’ selloff is also pushing that benchmark into a “buy zone” for some long-term investors.

“Our central case is that the economy does slow next year as Fed policy will still be restrictive,” Roger Hallam, global head of rates at Vanguard, said in an interview. That means, for the company, when the 10-year yield is above 4% “there is an opportunity to start to lengthen our portfolios’ duration with that sort of downside growth impulse in mind next year.”

That will allow the company to slowly “move to more overweight bonds,” he added.

Since around early September, Vanguard has also been benefiting from a tactical short wager in Treasuries as yields began to rise. The company remains in that short-term trade, though it has trimmed the size from its original level.

What to Watch

Note: The US bond market will be closed Oct. 14 in observance of a holiday

• Economic data:

  • Oct. 15: Empire manufacturing; New York Fed 1-year inflation expectations; monthly budget statement

  • Oct. 16: MBA mortgage applications; New York Fed services business activity; import and export price indexes

  • Oct. 17: Retail sales; Philadelphia Fed business outlook; initial jobless claims; industrial production; capacity utilization; business inventories; NAHB housing index; TIC flows

  • Oct. 18: Housing starts; building permits

• Fed calendar:

  • Oct. 14: Minneapolis Fed President Neel Kashkari: Fed Governor Christopher Waller

  • Oct. 15: Fed Governor Adriana Kugler; San Francisco Fed President Mary Daly

  • Oct. 17: Chicago Fed President Austan Goolsbee

  • Oct. 18: Kashkari; Waller

• Auction calendar:

  • Oct. 15: 13-, 26-week bills; 43-day CMB

  • Oct. 16: 17-week bills

  • Oct. 17: 4-, 8-week bills

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