US Treasury Yields Navigate Fed Uncertainty, Government Shutdown Risk

US Treasury Yields Fluctuate Amid Labor Market Data and Fed Policy Speculation

Financial markets experienced volatility last week as Federal Reserve officials expressed differing views on monetary policy alongside stronger-than-expected economic data. As a result, traders have scaled back bets on further easing by the Fed.

However, the market faces a significant hurdle: a potential federal government shutdown starting on October 1st, which could delay the release of critical data, including Friday's closely watched nonfarm payrolls report.

A weakening labor market prompted the Fed to implement its first rate cut of the year this month, and traders see an approximately 80% chance of the Fed cutting rates again at its October 28-29 meeting. However, they may need more soft data to validate the view that the labor market is cooling, reinforcing expectations of further Fed easing and keeping Treasuries on track for their best annual return since 2020.

James Athey, a portfolio manager at Marlborough Investment Management Ltd., states, "The jobs report is what's needed to drive a rally from here. It’s the most crucial piece of the ‘weak economy, dovish Fed’ story. But even if we do get the data, the bar is pretty high for a report weak enough to push Treasury yields lower from here." He added that he is underweighting US Treasuries.

The 10-year Treasury yield climbed to around 4.2% last week after falling to a five-month low of just below 4% on September 17th. At that time, the Fed resumed easing with a 25 basis point move, although Fed policymaker Neel Kashkari dissented, arguing for a 50 basis point cut. The rebound in Treasury yields was partly driven by data showing a decrease in initial jobless claims and robust U.S. economic growth in the second quarter.

These reports prompted traders to slightly reduce their expectations for easing, but they still heavily favor a 25 basis point rate cut by the Fed next month and potentially in December as well. The market has priced in about one percentage point of easing over the next 12 months.

Weak government jobs data in recent months has prompted the Fed to pivot, even with inflation above its 2% target, a move that helped boost bonds and put Treasuries on track for their best performance since 2020.

The market anticipates government data due on October 3rd will show the U.S. added 50,000 nonfarm payrolls in September, a rebound from an average of less than 30,000 in the prior three months. Fed Chair Jerome Powell said last week that the recent pace of job creation “appears to be running below the ‘breakeven’ level needed to hold the unemployment rate steady.”

He reiterated that Fed policymakers are facing conflicting risks of a slowing labor market and elevated inflation.

Officials have shown divisions on the path of monetary policy. Chicago Fed President Austan Goolsbee expressed concern last week about tariff-driven inflation and opposed any calls for repeatedly cutting rates "pre-emptively." Meanwhile, Governor Michelle Bowman said inflation is close enough to the Fed’s target to warrant more rate cuts because the labor market is weakening.

Market positioning also shows similar divisions. In the U.S. Treasury options market, there have been buyers betting that 10-year Treasury yields will fall to 4% or lower by the end of November. At the same time, a JP Morgan client survey showed short positions in U.S. Treasuries are surging.

Vanguard's global head of fixed income, Sara Devereux, believes that "the current level of the 10-year Treasury yield is largely fair, with a balance between downside risk from labor market fragility and upside risk from improving growth prospects."

She added that the company’s active fund managers tend to buy bonds when yields rise to the higher end of their recent range and favor bonds with maturities of 5 to 10 years.

The risk of a government shutdown also increases the importance of unaffected data, including the ADP private payrolls report on October 1st. While ADP is not always a reliable leading indicator for the official data, downward revisions to government data in recent months have corroborated weakness seen in the private reports. Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, says:

"ADP will carry tremendous weight, and a strong jobs number will open a lot of doors for questions about the rate path and the timing of rate cuts next year."