The expectation of interest rate cuts heats up as US bonds rise for five consecutive months. Will the fragile rally be shattered by the Federal Reserve's interest rate decision?

US Treasury yields have been rising for five consecutive months, while short-term yields sensitive to Fed policy have been pushed to the lowest levels in two years. The two-year Treasury yield, sensitive to policy changes, has dropped significantly from nearly 5% at the end of April to around 3.5% this week, reaching its lowest point since September 2022. This is due to easing price pressures and signs of weakness in the labor market, leading to increased expectations of a Fed rate cut. Bond investors who have been betting on the Fed's first rate cut in four years are about to find out if their trades are correct. At the beginning of September, the market was unanimous in expecting a 25 basis point rate cut this week. However, after reports of disagreement among Fed officials on whether to adopt a more aggressive policy path, traders increased their bets on a 50 basis point rate cut. Despite the uncertainty surrounding the Fed's policy meeting since 2007, traders betting on a significant rate cut have set a record. Therefore, if Fed officials ultimately choose a more moderate 25 basis point rate cut, traders who bet on a larger cut will face significant losses. Former New York Fed President Dudley recently stated that the Fed faces a critical decision at this week's meeting: whether to make a modest 25 basis point rate cut or to cut rates by 50 basis points to prevent an economic downturn. Dudley believes that Fed Chairman Powell favors a more aggressive approach, as Powell mentioned last month that further softening in the labor market is "unwelcome" and it appears that the employment market is indeed deteriorating. Dudley also stated that monetary policy is currently in a tightening phase when it should be neutral or accommodative. If a larger rate cut is made, the Fed can more easily align its dot plot predictions with market expectations, rather than surprising the market with an unsupported and unwelcome action. George Catrambone, head of the fixed income division at DWS Americas, stated: "The Fed will have to strike a balance in this regard. In terms of the extent of rate cuts priced in by traders, this is an imbalanced market." Edward Harrison, a macro strategist at Bloomberg, stated: "For the already significantly rising US Treasury yields, if the Fed chooses a 25 basis point rate cut, then most risks will be on the downside. More importantly, if the Fed really cuts rates by 25 basis points, it might signal a further 25 basis point cut in the subsequent news conference. This means that the current market's expectation of a 116 basis point rate cut by the Fed before the end of the year will face a repricing." Some market participants believe that expectations of rate cuts, whether this week or next year, have gone too far. John Brady, managing director at RJ O'Brien, stated: "This will be a life or death struggle. The key question is whether the Fed Chair has the full support of the Federal Open Market Committee (FOMC) for a 50 basis point rate cut." Daniel Ivascyn, who manages the world's largest actively managed fixed income fund at PIMCO, stated: "We do believe that the market may be getting ahead of itself in terms of expectations for rate cuts. There is a risk of a resurgence in inflation in the coming months, which could result in rate cuts that are lower than what the market is currently pricing in." In addition to rate cuts, factors affecting the US bond market include Fed officials' forecasts for overall rate cuts over the next two years and Powell's tone during the news conference. Over the past two years, US bonds have tended to rebound after the Fed announces its rate decisions. For example, out of the 20 days when rate decisions were announced, the 10-year Treasury yield dropped on 17 days, with an average decline of 7 basis points. Sinead Colton Grant, Chief Investment Officer at New York Bank Wealth, stated: "The Fed relies on data, and we believe the US economy may experience a soft landing. With a few soft jobs reports and further slowing inflation, the 10-year Treasury yield could fall to a low of 3% to 3.25%."