Stretched Valuations: Why the Bond Market's Next Move Hinges on Jobs Data

Summary:

• Nonfarm Payrolls as a Market Driver. Friday's NFP report is crucial for market sentiment, with economists expecting a rebound to 165k jobs and a slight drop in the unemployment rate to 4.2%. A stronger labor market will likely reduce the chances of aggressive rate cuts, while a weak report could trigger faster and deeper cuts.
• Bond Market Valuations Are Stretched. Current bond market pricing reflects expectations of significant rate cuts (100 bps by year-end, 215 bps by September 2025). However, unless economic and labor data deteriorate rapidly, further bond price gains are limited, and yields may remain elevated.
• Limited Upside for Treasuries: Even in the face of stock market volatility, Treasuries are offering limited relief. Long-term Treasuries may see only modest gains unless the Fed cuts rates aggressively, and the yield curve is unlikely to see dramatic steepening without a significant economic slowdown or fiscal changes driven by the upcoming U.S. election.

Analysis of the Upcoming Nonfarm Payrolls and the U.S. Bond Market Outlook.

As we approach the release of Friday’s nonfarm payrolls (NFP) report, consensus expectations from Bloomberg’s economist survey show that the labor market data is expected to rebound after a weaker July report. Out of the 61 economists surveyed, the consensus for the NFP is around 165,000, with only one economist predicting a figure lower than July’s 114,000. Additionally, the unemployment rate is expected to drop slightly to 4.2% from July’s 4.3%. This setup creates a pivotal moment for markets, as the NFP report will heavily influence the direction of bond markets, interest rate expectations, and overall market sentiment.

Implications of the NFP Release

1. If NFP Exceeds Expectations: Should the NFP show robust job growth and the unemployment rate decreases as expected or more, markets will likely adjust their expectations for future rate cuts. A stronger labor market would reduce the likelihood of aggressive rate cuts by the Federal Reserve, leading to a re-pricing of interest rate expectations.
• Impact on Rate Cuts: Markets would likely price only a 25 bps rate cut in September and potentially reduce the odds of a 50 bps rate cut later in the year.
• Bond Market Response: In this scenario, bond yields, especially at the longer end of the curve, could stabilize or even rise, as a stronger labor market would indicate that the Fed does not need to ease monetary policy as aggressively. Long-term yields would remain elevated as expectations for economic resilience increase, reducing the likelihood of a significant bond bull rally.
2. If NFP Falls Below Expectations: On the other hand, if NFP growth disappoints, with jobs coming in significantly below the consensus of 165,000, and the unemployment rate does not decline, the market will likely anticipate more aggressive rate cuts.
• Impact on Rate Cuts: In this case, there is a strong likelihood that markets will price in a 50 bps rate cut in September, with additional significant cuts expected before the year’s end. The market would price in a deteriorating labor market and economic conditions, which would support the case for a faster and deeper rate-cutting cycle.
• Bond Market Response: This would likely drive a bond market rally, especially in the short to medium tenors, as yields would fall on expectations of a rapid rate-cutting cycle by the Fed.

Current Bond Market Valuation and Outlook

As of now, bond valuations are stretched, reflecting the market's belief that the Fed will enact a total of 100 bps in cuts by the end of the year. Additionally, markets have priced in 215 bps of rate cuts by September 2025, implying eight and a half rate cuts. This means bond markets are already pricing in a significant economic slowdown or recession, as well as a dovish response from the Fed. However, this leaves little room for further appreciation in bond prices unless the labor market and economic data deteriorate rapidly.

Treasury Performance Amid Stock Market Selloff

Recent market action further demonstrates how limited bond price gains may be in this environment:

• S&P 500 fell by 2.12%, indicating heightened stock market volatility.
• U.S. Treasuries across tenors gained only 0.5%, while longer-term Treasuries (10+ years) rose by 1%, and 1-3 year Treasuries increased by only 0.4%.

This limited movement in Treasuries suggests that even in times of stock market volatility, bond markets are not providing significant relief to portfolios. Long-term Treasuries have shown some strength, but with yields on the 10-year around 3.8%, further gains in bond prices would require a scenario where the Fed cuts interest rates aggressively and pushes the Fed funds rate below 3%.

Key Considerations for the Future of Bond Yields

1. Gradual Yield Curve Steepening: The yield curve steepening is already underway as markets expect rate cuts, but the extent of the steepening will likely be modest. Assuming the Fed cuts rates in line with expectations and the Fed funds rate hits 3.15% by September 2025, the 10-year Treasury yields, currently around 3.8%, may only decline slightly. A larger drop in long-term yields is unlikely, as the spread between ten-year yields and the Fed Fund rate is likely to increase.
2. Soft Landing and Economic Growth: An important dynamic to consider is the possibility of a soft landing for the economy. If the Fed manages to reduce rates while avoiding a recession, the economy could exhibit stronger growth in the future, which could lead to a rebound in long-term yields. In this case, long-term Treasuries might not see the large price gains investors are hoping for, as a better-than-expected economic environment would drive yields higher.
3. Fiscal Spending and U.S. Elections: The long end of the yield curve is also vulnerable to increased fiscal spending, especially in light of the upcoming U.S. elections. Potential shifts in fiscal policy, such as higher government spending or increased deficits, could put upward pressure on long-term yields, adding another layer of risk to long-duration bonds.

Conclusion: Where Are We Headed?

The bond market’s current pricing suggests that a duration-heavy strategy may not deliver significant returns from here unless the labor market weakens sharply and the Fed enacts a more aggressive rate-cutting cycle than is currently expected. With four rate cuts already priced by the end of the year and over 200 bps of cuts expected by September 2025, valuations appear stretched.

In this environment, duration risk seems less attractive. Yields on the longer end are unlikely to fall dramatically unless the Fed's policy becomes more accommodative than anticipated, which would require a marked deterioration in economic conditions. As the labor market data unfolds, it will provide crucial signals for how to position in both bonds and broader financial markets. If the economy remains resilient, the bond market may face headwinds, and yields could rise as markets adjust expectations for the Fed's rate path.