Sell the Fed News
At Friday’s close, the market expects less than a 5 percent chance the Fed moves by more than a quarter point because jobless claims and BLS revisions, even though worse than expected, do not suggest that the unemployment rate is higher than what the non-farm payrolls reported.
This may be the reason the market "sells the Fed news," as the rate cut is not perceived as a safeguard against a spike in the unemployment rate, despite the risk of such an increase.
Remarkably, over the past one and a half months, despite poor labor data, Fed Funds futures rallied only 10 basis points. Meanwhile, the chances of a cut rose from 40 to 104 percent, causing 2Y and 10Y Treasury yields to decline by 50 basis points (Figure 1).
Thus, overbought conditions characterize the set-up for rates going into the FOMC meeting, e.g., 10Y Treasury futures RSI is near 70, the yield curve has flattened, and yields are trading at the lower end of the range, close to the lows seen around Liberation Day.
Bonds may “sell the news” on a (widely expected) 25-basis point cut, unless the Fed decides to surprise with a larger move (which remains my view). In other words, a 25bps is a “good news cut” of adding modest accommodation rather than going big to protect the economy against the downside.
Figure 1: Probability of a rate cut, 2Y and 10Y yield (%)
Source: CME, US Treasury
If bonds are selling the news, the stock market could interpret this as a positive signal. Yields may be too low relative to the current economic conditions; activity has slowed, the labor market has entered a new stage with demand staying subdued, but these factors are not yet causing GDP to fall back into contraction.
Thus, positioning in bonds has not changed over the past month despite a solid decline in yields. The shorts have, in fact, increased, as the real-time economy stayed afloat (Figure 2).
This ponders the question of what is driving yields; of the 27-basis point decline in the term premium since early August, twenty-one accounts for the Fed, and six basis points for inflation. Yields, however, are down nearly half a percent; thus, an extra number of ~15 basis points is “unexplained.”
As the stock market rallied, the fall in the term premium suggests that investors have accumulated bonds to diversify, and may have done so through auctions, which are characterized by higher-than-normal demand. Furthermore, the latest developments in AI, IPOs, and mergers are supercharging credit.
Figure 2: GDPNow (Y/Y%) and net-positioning (10000s, contracts)
Source: Atlanta Fed, CFTC
That is the real story underneath the conundrum so typically associated with bond rallies. Indeed, Treasuries had a good month, but so did credit, which issued a robust $150 billion since the August weak NFP report, on par with the issuance in 2024 over the same period.
What stands out is that companies planning to merge and invest in AI and the cloud have seen their corporate bonds surge in value (Figure 3). The hot IPO companies that came to market recently or plan to are also issuing bonds (Figure 4).
A rate cut or more by the Fed is likely to accelerate corporate bond issuance, potentially matching the 2023/2024 records of $1.7 trillion. Credit spreads may fall below 1997-199 records set before LTCM, as rising Treasury yields towards 4.25% support further narrowing. It is a “sell the Fed news” rate cut.
Figure 3: Credits surge (spread, bps)
Source: MarketAxxes
Figure 4: Recent IPOs and debt issuance
Source: Market Watch