The challenges ahead of a bond bull market

Expectations for interest rate cuts might be ahead of themselves. Markets are pricing for five rate cuts next year starting in May, estimating that the Fed Fund rate will drop to 4.25% by January 2025.

Consequently, during the past few weeks, yields dropped across maturities, easing financial conditions when inflation remains well above the Fed's target and job data remains resilient. Easing financial conditions set the ground for the market to envision a soft landing, providing fertile soils to a bull stock market.

However, there is none so deaf as those who will not hear. Indeed, investors rejected Jerome Powell's attempt to push back on such expectations last Friday. Not only did Powell say that interest rate cuts are not on the horizon, but he warned that the central bank might tighten even further. With financing conditions easing abruptly, the chances for a final rate hike rise.

Even if macro data show lower inflation and higher growth risks, markets will find it challenging to justify expectations for such aggressive rate cuts going forward.

According to September’s FOMC economic projections, the Federal Reserve expects to cut rates only twice next year, with core PCE inflation ending the year at 2.6%, unemployment at 4.1%, and real GDP at 1.5%. In contrast, markets expect the Federal Reserve to cut rates five times, despite economists expecting core PCE to end the year well above target at 2.7%. The disconnect between the expected monetary policy path and inflation expectations is striking, and it's likely to be challenged as the Federal Reserve doesn't move from its hawkish stance.

This week’s jobs data are going to be an important focus. Consensus expects a +180k nonfarm payrolls, an unchanged unemployment rate, and stable average earnings. Yet, the unemployment rate might trump all the other readings, as the latest figure came at 3.9%, just 30bps higher than when the Fed began to hike interest rates in March last year. A higher-than-expected unemployment rate might be a signal that the labor market is cooling faster, fostering speculation that monetary policies need to be easier.

However, the real test will come next week, with the U.S. Treasury selling 3- and 10-year notes on Monday and 30-year bonds on Tuesday ahead of the FOMC. These auctions will be vital in understanding whether investors are buying Treasuries at current levels and extending duration ahead of the FOMC meeting. Then, the attention will turn to the Federal Reserve's new set of dot plots and economic forecasts.

Fiscal woes will return in the first quarter of 2024

Investors should carefully consider duration risk in light of the upcoming Quarterly Refunding Announcement (QRA) in January, which will likely show more coupon issuance going forward.

The average coupon the Treasury pays on government bonds has risen to 2.5%, the highest since 2012. That means the U.S. Treasury will need to raise approximately $768 billion a year in new debt to service outstanding and rolling debt, even if there is no further increase in fiscal spending. That represents an increase in the overall Treasury’s debt issuance of 4.5% per year.

The Treasury Borrowing Advisory Committee (TBAC) recommends that the U.S. Treasury increase coupon issuance by $50 billion across maturities during the first quarter of 2024. The tenors to be increased the most are the 2-, 5-, and 10-year, whose selling size is recommended to rise by $9bn each per quarter ($3bn per auction). In a nutshell, from the issuance of $35 billion 10-year notes in the first 10-year reopening in September 2023, we are passing to a first reopening of $38 billion in December 2023 and $41 billion in the first 10-year reopening in March 2024. Although the Treasury is not bound to TBAC suggestions, they are normally followed, providing a good picture of forward issuance.

By limiting our analysis to the 10-year sovereign, it's easy to appreciate that the Treasury bond issuance is expected to increase beyond what markets have been used during the COVID-19 emergency.