Are U.S. Treasuries the Biggest Loser of the Fed's Rate Cut?

The Federal Reserve's "surprise" rate cut of 50 basis points last week sent the U.S. stock market into a frenzy of jubilation. However, Bloomberg macro strategist Simon White believes that this rate cut decision could lead to greater price and liquidity risks in the U.S. Treasury market, making it the biggest loser.

Nobel laureate in Economics, Milton Friedman, once used the vivid metaphor of a "fool in the shower" to describe the potential lag in central banks' monetary policy formulation. He argued that adjustments in central bank policies often lag behind actual economic conditions due to excessive optimism, leading to unsatisfactory policy outcomes.

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The Fed's rate cut this time may be confirming Friedman's view. With the economic outlook still uncertain, a too-quick rate cut could exacerbate the term premium of long-term debt, posing greater liquidity risks to the U.S. Treasury market.

Rate Cut Leads to Bearish Tendencies in the Bond Market

White believes that inflation and its volatility are the two biggest risks facing long-term debt.

After the Fed cuts rates, inflation volatility tends to increase significantly more than during rate hikes or when holding steady.

Typically, after the Fed eases policy, the yield curve steepens, signaling a positive economic outlook. However, White argues that in the current cycle, due to liquidity and inflation risks, the rise in long-term bond yields leads to a bearish steepening of the yield curve, which could become the norm.White points out that, according to historical data, interest rate cuts typically lead to an increase in the term premium of long-term Treasury bonds. The term premium reflects the additional yield required by investors to hold long-term bonds as compensation for the uncertainty of inflation and its trajectory.

Furthermore, there is a significant positive correlation between the unexpectedness of interest rate cuts and the term premium and yield curve; the greater the unexpectedness, the steeper the yield curve. Last week's interest rate cut decision was seen as the largest downward surprise in the past two decades, excluding crisis and bear market conditions. This uncertainty has made market expectations for future economic trends more cautious.

Although the Federal Reserve has set expectations for a 50 basis point interest rate cut, the current economic conditions do not show signs of recession. This means that such a large interest rate cut may not be necessary. White stated that this implies a higher possibility of an unexpected rate hike (the Federal Reserve's interest rate cut is lower than market expectations), hence the term premium rises, causing long-term yields to increase.

"All of this together creates a perfect storm for long-term yields: greater uncertainty, lower rates, and the negative impact on risk assets due to rates exceeding expectations."

Increased liquidity, worsening fiscal deficits, and increased inflation risks... the outlook for U.S. Treasuries becomes more severe.

Currently, the liquidity of the U.S. Treasury market faces a severe challenge. The Bloomberg Treasury Liquidity Index recently hit a new high, indicating poor liquidity in the U.S. Treasury market. Although the index has retreated from its peak, it remains at a high level for most of the past 15 years.

"Regardless, after the Federal Reserve's easy monetary policy leads to increased inflation volatility, liquidity risks are destined to rise again."

In addition, with the federal government's fiscal deficit reaching $1.5 to $2 trillion, inflation risks have significantly increased, making the liquidity outlook for the Treasury market even more severe.White noted that over the past two years, the issuance of U.S. Treasury bonds has increased sharply to meet the burgeoning borrowing needs. However, the current issuance is trending towards stability, leading to a significant extension in bond maturities.

"With the government borrowing heavily and the Federal Reserve exacerbating inflation risks, the market may not be willing to continue purchasing long-term Treasury bonds at current prices.

Therefore, as the market demands a greater margin of safety for holding government debt, the term premium may rise."