The following weeks promise to be volatile. Bond prices have surged on expectations that the Federal Reserve will soon begin slashing interest rates to stave off a recession, raising concerns that investors may once again be underestimating the strength of the US economy. For memory, they have been wrong for the last two years.

The rally extended this week, pushing the yield on two-year US Treasuries down to about 3.85% from over 5% in late April. Over the past four months, this climb marks the most extended gains since 2021.
This surge has been driven by speculation that the Fed will cut its benchmark rate by more than two percentage points over the next 12 months – a reduction not seen outside of a recession since the 1980s. For bond bulls, this creates the risk that a resilient US labour market, which showed signs of cooling in July, could bounce back, leading the Fed to take a slower approach to easing. The first significant test comes on Friday, releasing August payroll data. Economists expect a rebound in job growth and a dip in unemployment.

The bond market is pricing in rate cuts rarely seen outside of recessions, with a Fed policy reduction of over 200 basis points now anticipated within the following year. Since late April, US Treasuries have yielded over 6%, as investors expect cooling inflation to allow policymakers to start cutting rates from their current two-decade high.
This echoes last year’s rally, which reversed when it became clear that the Fed wouldn’t move as quickly or aggressively as expected. Yet, the latest jobs report from the Labour Department showed unemployment hitting a near three-year high and wage growth slowing to one of the weakest rates since the pandemic, briefly raising fears that the Fed had waited too long to start easing and that the economy was headed for a downturn.
At the recent Jackson Hole symposium, Fed Chair Jerome Powell shifted the Fed’s priority from tackling inflation to protecting jobs, signalling that any further labour market slowdown would be “undesirable.” Powell’s omission of the word “gradual” to describe future rate moves was seen by some investors as paving the way for quicker action.

Investors now anticipate that the Fed will cut rates by 75 bps points by the end of the year, remaining three meetings in 2024.
With policymakers still mindful of recent inflationary pressures, the critical question is whether the labour market has weakened enough to justify these easing expectations.
Unfortunately, the signals are mixed. While the recent Conference Board survey showed fewer jobs were plentiful, weekly jobless claims have remained steady in recent months. Economists expect the September 6 payroll report to show job growth accelerating from 114,000 to 165,000 and unemployment ticking down from 4.3% to 4.2%.
As a result, some investors and strategists are inclined to dismiss the bond rally.
Besides, based on the data, it’s hard to see how rate cuts of over 200 basis points could be justified, given that the National Bureau of Economic Research (NBER) responsible for identifying and dating business cycles will need two consecutive negative quarters. Regarding the current data, it looks unlikely for the last three quarters. The economy is moving relatively slowly; only a rapid market decline, similar to what we’ve seen recently, triggering a recession-inducing feedback loop, would justify the anticipated deep cuts.