Long-term Treasury bond options show that the outstanding open positions predicting a bond rally and lower interest rates are 2.5 times larger than those protecting against a decline. Conversely, bearish positions in the stock markets are twice as significant as the opposite, indicating that the market is preparing for a correction.

This imbalanced positioning suggests that the upward trend in bonds compared to stocks is nearing its highest level since 2005, reflecting the belief that a turning point in the U.S. economy is imminent.

The yield on two-year Treasury bonds has dropped by approximately 14 basis points to 4.54%, the lowest level since June. Swap contracts anticipating the outcomes of Fed policy meetings predict an effective rate of around 4% by December 2024, down from the current 5.33%, representing a nearly 125 bps decrease in interest rates.

The extreme optimism towards bonds over stocks is not entirely without merit. Overall inflation, which stood at 6.5% at the end of last year, has since halved. Core PCE, the Federal Reserve’s preferred indicator, is now 3.5%, lower than the Fed’s year-end estimate of 3.7%.

These advances in combating inflation have led to bets that the Fed will reduce its benchmark rate by up to 125 basis points by the end of 2024, which is not a reality but an unlikely scenario.

However, Fed Chairman Jerome Powell dashed hopes of rate cuts last week, stating, “It would be premature to conclude with certainty that we have reached a sufficiently restrictive stance or to speculate on when policy might be eased.” In a speech in Atlanta, the Fed chief indicated that policymakers were considering keeping interest rates steady when they meet on December 12-13, giving them more time to assess the economy.

The prospect of a higher neutral rate will also deter the Fed from easing its policy too quickly. Indeed, the Fed believes that the neutral rate, which does not stimulate inflation while maintaining the labour market, has increased.

In this context, the rise in Treasury bonds that has pushed 10-year yields down by about 75 basis points from a peak of 5.02% seems highly exaggerated. Indeed, Fed officials forecast rates between 5% and 5.25% by the end of next year, according to their median projection released in September, only a quarter-point lower than the current level.

The U.S. economy is indeed faring much better than policymakers had estimated. The Fed, which predicted economic growth of only 0.5% for 2023 at the same time last year, has since revised its estimate upward to 2.1%. Next year, it forecasts growth of 1.5%, which would be lower than its estimated long-term trend growth of 1.8%. However, investor expectations remain excessive and could lead to increased volatility in financial markets in the coming months.