Bond investors expect the Federal Reserve to lower rates by 25 basis points on Thursday, but they are also preparing for the Fed to slow its rate-cutting pace in 2025, as they expect inflation to rise under Trump's administration.
Given the stickiness of U.S. inflation, market participants are moving away from long-term U.S. Treasuries, preferring to hold shorter-term Treasuries, such as those with maturities of 2 to 5 years.
Concerns over rising inflation typically lead to sell-offs in long-term U.S. Treasuries and push up Treasury yields, as investors demand higher premiums to compensate for the risks of holding long-term bonds.
The market widely expects the Federal Reserve to lower its benchmark overnight rate by 25 basis points to a target range of 4.25%-4.50% following a two-day policy meeting, but what action the Fed will take afterward remains an open question.
At least one bank — BNP Paribas — believes the Federal Reserve will keep rates unchanged throughout next year and begin cutting rates again in mid-2026. Other institutions expect two to three cuts of 25 basis points each.
George Bory, chief investment strategist for fixed income at Allspring Global Investments, stated, 'The hawkish rate cuts align with data trends and potential policy changes under the new administration; the Fed is trying to prepare the market for a slowdown in the pace of rate cuts... and increase flexibility to track the data and be ready for policy changes.'
Recent data shows that the U.S. economy is resilient: the job market continues to create jobs, and inflation remains excessively high in November. The core CPI in the U.S. rose by 0.3% month-on-month in November for the fourth consecutive month, indicating a stagnation in progress towards the Fed's 2% inflation target.
Investors will also focus on the economic and interest rate forecasts released quarterly by Federal Reserve policymakers, known as the ‘dot plot’, which reflects officials' expectations for the extent of rate cuts. The 'dot plot' released during the September meeting indicated that rates will drop to 3.4% by the end of 2025.
The Federal Reserve raised interest rates by 5.25 percentage points from March 2022 to July 2023, pushing the policy rate to a range of 5.25%-5.50% to combat surging inflation.
Greg Wilensky, head of fixed income at Janus Henderson Investors, stated, 'The dovishness of the Federal Reserve's latest economic forecast will be less than in September, given the comments made by Chair Powell — the economy is stronger than they previously thought when they considered a 50 basis point cut.'
Wilensky added, 'I believe they will raise the 2025 rate forecast by about 25 basis points.' He noted that his bond portfolio is currently overweight in U.S. Treasuries with maturities under 10 years and underweight in those with maturities over 10 years.
Long-term bonds are not favored.
Bond investors have been extending duration throughout the year, i.e., purchasing longer-dated assets, as they prepare for Fed rate cuts and a potential economic recession. As rates decline, higher-yielding U.S. Treasuries become more attractive, leading to price increases.
For example, 5- to 10-year U.S. Treasuries are sensitive enough to capture price increases when rates fall, but their interest rate risks are lower than those of long-term U.S. Treasuries.
However, some investors have recently reduced duration, shifting focus to short-term U.S. Treasuries or remaining neutral.
Jay Barry, global rates strategist at JPMorgan, said, 'No one really wants to actively extend duration right now, which reflects a more tempered rate cut cycle.'
Data from the Commodity Futures Trading Commission (CFTC) show that ahead of this week's Federal Reserve meeting, asset management companies have reduced their net long positions in long-term assets (such as Treasury futures), while leveraged funds have increased their net short positions in that asset.
Bory from Allspring indicates that investors are generally moving away from the long end of the yield curve, depending on the supply of U.S. Treasuries and long-term inflation expectations.
Market participants expect inflation to accelerate again as President-elect Trump is about to take office with plans for tax cuts and tariffs on a range of imported products. These measures could widen the fiscal deficit, putting pressure on the long end of the yield curve and pushing up its yields.
Kathy Jones, chief fixed income strategist at Schwab, stated, 'Tariffs pose a potential inflation risk as they lead to higher import prices. They could ultimately result in a one-time price shock or become a sustained source of inflation.'
BNP Paribas expects that due to tariffs and other factors, the year-on-year growth rate of the U.S. CPI will reach 2.9% by the end of next year and 3.9% by 2026. Due to rising inflation, the bank expects the Federal Reserve to maintain interest rates unchanged in 2025.
James Egelhof, chief U.S. economist at BNP Paribas, stated that given the resilience of the economy and growing concerns that monetary policy may be approaching neutrality, the Federal Reserve has shown a 'reluctance to cut rates.' He said, 'The Fed will not be able to ignore the temporary resurgence of inflation driven by tariffs.'
Article republished from: Jinshi Data