Market Anticipates Fed Rate Cut Next Week as 10-Year Treasury Yield Dips Below 4% – Boom or Bust?

TradingKey - On Thursday, September 11, intraday trading saw the yield on the 10-year Treasury note briefly fall below 4%, marking a five-month low. This movement was prompted by the release of August CPI data indicating that inflation is under control, while initial jobless claims surged to a four-year high, underscoring weakness in the labor market. These figures bolstered market anticipation of the Federal Reserve cutting rates in September.

According to the CME FedWatch tool, the federal funds futures market now sees a 92.7% probability of a 25-basis-point rate cut in September, and a 7.3% chance of a 50-basis-point cut. This expectation has driven down the 10-year Treasury yield.

ING rate strategist suggests that the market reaction may be somewhat exaggerated, noting that the neutral level for 10-year Treasury yields is within the 4.24%-4.50% range. They stated, "The current inflation environment suggests we should or may return to this level." Additionally, the prevailing high fiscal deficits support this yield level.

Guneet Dhingra, BNP Paribas' head of U.S. rate strategy, specifically pointed out that this "excessive" reaction might be due to signs of a weakening labor market. He remarked, "Nowadays, any indication of a weakening labor market makes investors highly cautious, fearing the Fed might accelerate its easing pace."

Some analysts argue that the declining yield is both a positive for the stock market and a potential recession signal. On the one hand, a drop in yields reduces corporate and borrowing costs, but on the other, lower long-term bond yields often imply declining investor confidence in the U.S. economic outlook, leading to a lower premium expected for future asset returns.

MarketWatch reported earlier this week that the recent substantial drop in the 10-year Treasury yield from the year's start is mainly dragged by expectations of slower economic growth. FHN Financial strategist Will Compernolle noted that the decline in the 10-year yield suggests a dramatically different macroeconomic environment compared to the beginning of the year, when markets anticipated faster economic growth and rising inflation in 2025.

Derek Tang, an economist at Monetary Policy Analytics, mentioned that the current 10-year yield could be seen as a recession indicator, potentially reflecting market concerns about the Fed's independence. He believes that while the yield drop is partly tied to rate cut expectations, the crucial factor is whether the Fed is cutting rates proactively or reactively.

He refuted the notion that all rate cuts are beneficial for U.S. stocks, arguing that only proactive cuts may be favorable, as they represent the Fed's efforts to "prevent a recession and provide a safety net." Conversely, reactive rate cuts imply the Fed is merely responding to an already established "momentum of economic slowdown or recession," which would put pressure on the stock market.