In the aftermath of the Federal Reserve's entry into a rate-cutting cycle, financial markets have displayed surprising resilience, with U.S. Treasury yields and the dollar both experiencing significant gains. This unexpected trend unfolded on October 21, when bond prices across all maturities plummeted, causing a steep rise in yields. The data from Investing indicates a notable increase: the yield on two-year Treasuries jumped by 7.1 basis points to 4.032%, the five-year yield rose by 9.1 basis points to 3.985%, and the ten-year yield surged 10.7 basis points to reach 4.182%. The thirty-year yield also followed suit, climbing by 10.4 basis points to 4.486%.

At the same time, the U.S. Dollar Index robustly crossed the 104 threshold, climbing by 0.53% to end the day at 104.01. According to data from the Commodity Futures Trading Commission (CFTC), speculative traders have nearly wiped out the net short positions in the dollar that were established in July. These movements in the financial markets have raised important questions about the sustainability of their upward trajectory.

Dong Zhongyun, Chief Economist at AVIC Securities, provided an analysis for journalists, highlighting the aggressive measures taken by the Federal Reserve in September, which initiated the rate-cutting cycle with a 50-basis-point reduction. This aggressive stance had initially led to soaring expectations of market accommodation. However, subsequent economic data revealed that the U.S. labor market was buoyantly resilient, coupled with inflation figures surpassing expectations. Additionally, Fed officials have increasingly hinted at a gradual approach to future rate reductions. The situation has been further complicated by rising approval ratings for former President Donald Trump, a Republican candidate, heightening market concerns over potential inflationary pressures. Such a confluence of factors has significantly dented market expectations for easing, driving both Treasury yields and the dollar index higher.

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What remains to be seen is whether these remarkable performances can be sustained in the wake of rising yields and a strengthening dollar.

Interestingly, yields have risen contrary to the prevailing trend typically seen during rate-cutting cycles. Notably, on October 21, the ten-year Treasury yield soared to approximately 4.2%, marking its highest level since July 30, while the two-year yield also crossed the 4% mark—a phenomenon that has far exceeded Wall Street’s expectations.

Wang Youxin, a senior researcher at the Bank of China, elaborated further on this trend, attributing the rise in Treasury yields and the dollar to recent economic data exceeding expectations, particularly in employment and retail sectors. As the fears of a U.S. economic recession have subsided, the landscape appears less daunting. Inflation has shown a slower decline, and Trump’s rising political stock ahead of the elections has prompted market apprehension about potential inflation rebounds. This shift in sentiment appears to have recalibrated expectations regarding the Fed’s rate-cutting cadence, thereby propelling both Treasury yields and the dollar upward. The prevailing geopolitical tensions have added layers of uncertainty, contributing to a growing demand for safe-haven assets such as the dollar.

Arif Husain, the Chief Investment Officer of Fixed Income at T. Rowe Price, has commented that due to rising inflation expectations and concerns regarding U.S. government spending, the ten-year Treasury yield may soon touch the significant 5% mark.

Husain clarified that the Fed's rate cuts in this cycle may not be as pronounced as previously seen, drawing parallels to the reductions experienced between 1995 and 1998. With a recession in the U.S. economy appearing less likely, investors should brace for higher long-term Treasury yields. The Fed's balance sheet reduction has effectively eliminated a key source of Treasury demand, as the U.S. Treasury continues to issue bonds to address governmental deficits, flooding the market with new supply.

The U.S. Treasury's own data indicate that during the fiscal year of 2024 (October 1, 2023, to September 30, 2024), the federal government is projected to have a historic fiscal deficit of $1.83 trillion, marking the third-highest deficit in history, with net interest payments on the entire year’s debt estimated to surge to about $882 billion.

Economists broadly concur that, regardless of who emerges victorious in the approaching elections, America's debt trajectory will continue upward. The Committee for a Responsible Federal Budget estimates that the economic plan put forth by Vice President Kamala Harris, the Democratic candidate, would result in an additional $3.5 trillion in debt over a decade, while Trump’s agenda is projected to inflate the debt by a staggering $7.5 trillion.

Market uncertainties stemming from the upcoming elections have, in tandem, bolstered the dollar. According to Patrick Locke, a strategist at JPMorgan, investor bets on a rising dollar ahead of elections have catalyzed a surge in dollar demand last week, a trend likely to continue. "Election trading has become increasingly prominent," he stated, noting that while investors have already begun buying dollars, their overall positioning is still relatively neutral, leaving significant room for additional hedging trades in the weeks leading up to the elections.

The call for a pause in rate cuts has intensified, as economic data remains volatile. Fed officials express uncertainty regarding future policy paths.

Logan from the Dallas Fed articulated that, given the multitude of uncertainties clouding the economic environment, the Fed should exercise caution in its rate-cutting strategy, favoring a "gradual" approach. Economic, political, and market shocks could potentially alter the trajectory, pace, and ultimate levels of interest rate adjustments.

Similarly, Kashkari from the Minneapolis Fed expressed support for the 50-basis-point cut implemented last month but anticipates future reductions may be more modest, suggesting that today’s neutral rate might be higher than in the past. Should the job market deteriorate sharply, the Fed may accelerate the pace of its rate cuts.

The extent to which the Fed ultimately reduces rates remains uncertain. Kansas Fed's Schmidt is also inclined to decelerate the rate-cutting path, which would enable the Fed to identify the neutral rate level—one that neither hampers nor stimulates the economy.

In general, these ambiguous statements have failed to furnish clear guidance on the future course of monetary policy. The interest rate markets are predicting a reduction of 39 basis points in the next two Fed meetings, with an almost 50% chance seen for a halt to the cut cycle before the year's end.

Torsten Slok, chief economist at Apollo Global Management, noted that with the robust performance of the U.S. economy, the likelihood of Fed officials maintaining the interest rate at its current level in November is increasing. There are numerous reasons to believe the economic momentum will persist; these include the Fed’s dovish stance, soaring stock and real estate prices, narrowing credit spreads, and the very "open" avenues for corporate financing in public and private markets.

In Wang Youxin’s view, the growing call for the Fed to slow its rate-cutting pace or even pause reflects deep-seated uncertainties surrounding the Fed's policy expectations. This uncertainty might exacerbate divisions within the Fed itself. Upcoming economic data releases, such as the third-quarter GDP and October inflation figures, will significantly inform the Fed's policy decisions. If the data proves robust, it could diminish the need for further cuts; conversely, if it disappoints, it may provide more justification for a dovish stance.

The Fed is likely to adjust its policies according to the real-time performance of subsequent economic data. Consequently, the recent surges in employment and inflation figures are more indicative of transient market shifts rather than a definitive trend. Dong Zhongyun analyzed that the overarching expectation is for the economy and inflation to trend lower, while any fluctuations in rate-cutting expectations in response to emerging data will likely remain commonplace.

In light of this, it appears unrealistic for the rate cuts to persist at a 50-basis-point pace in the upcoming meetings; a more subdued rhythm of 25 basis points seems considerably plausible.

In the initial phase of this rate-cutting cycle, the simultaneous upswing in Treasury yields and the dollar is notable; however, sustaining this momentum over the long term poses challenges.

Dong Zhongyun believes that both the Treasury yields and the dollar are likely to trend downwards overall, albeit with considerable volatility. This trajectory will largely hinge on actual data performance and the Fed's anticipatory guidance. A seamless rate-cutting approach from the Fed could facilitate capital inflows from developed markets to emerging ones, a scenario that would favor such markets. However, if high Treasury yields and dollar persist, the latent pressure could lead to depreciation of emerging market currencies and heightened capital outflows.

The overarching trend remains that the Fed is expected to cut rates further. Daly from the San Francisco Fed indicated an ongoing expectation for the Fed to continue reducing rates to curtail any further weakening in the labor market. "As of now, I have yet to see any information suggesting we will not continue cutting rates. For an economy nearing a 2% inflation rate, current interest rates are exceedingly tight, and I wish to avoid further deterioration in the labor market," she stated.

In parallel, the Fed’s monetary policy will retain a degree of flexibility to adapt to evolving economic conditions. Wang Youxin posits that the Fed will recalibrate its monetary policy in response to key economic indicators such as inflation and employment statistics, alongside shifts in the international economic and financial landscape. Over the medium to long term, it appears that the average U.S. interest rate will largely remain on a downward trajectory, although short-term policies and market expectations are likely to entail fluctuations, impacting end-rate movements in unexpected ways.

The overall scope of the Federal Reserve’s upcoming rate cuts might not be exceptionally vast. Schmidt anticipates that rates will remain "well above" those seen in the decade prior to the COVID-19 pandemic, a condition driven by factors such as elevated productivity growth, increased investment, and burgeoning government debt. Additionally, structural forces, such as demographic aging—having been at play prior to the pandemic—remain relevant.

Powell from the Federal Reserve has articulated the prevailing uncertainties surrounding the assessment of neutral interest rates while definitively ruling out a return to the previously ultra-low rate era. Dong Zhongyun further explained that the current interest rates are still notably high, indicating significant room for downward adjustment. The endpoint for interest rates must strike a balance across various factors, including inflation risks, the sustainability of U.S. finances, and labor market dynamics, with rough estimates suggesting the terminal level of this rate-cutting cycle could be around 3%.