As the outlook for the Federal Reserve's interest rate cut path becomes increasingly "obscured by clouds and fog," bond investors are also starting to take defensive measures.

Last week, higher-than-expected US CPI and mixed labor market indicators led traders to further reduce bets on the extent of Federal Reserve rate cuts this year, while also pushing the 10-year US Treasury yield to its highest level since July.

A closely watched measure of expected volatility in US Treasuries, the BofA MOVE index, rose to its highest level since January.

Interest rate market traders currently estimate that there is about a 20% chance the Federal Reserve will keep rates unchanged at a meeting in November or December. In contrast, before the release of the September non-farm employment report, a combined 50 basis point rate cut at the two meetings was once considered a foregone conclusion in the industry.

At the same time, activity in the derivatives market, such as options, indicates that investors are hedging against fewer rate cuts by the Federal Reserve: much of the recent demand for Secured Overnight Financing Rate (SOFR) options has been concentrated on contracts that the Federal Reserve will only cut rates once more this year. Some extreme bets even anticipate that the Federal Reserve will pause its easing cycle early next year.

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In the past week, US Treasury prices have fallen sharply. The Bloomberg US Bond Index weakened for a fourth consecutive week, recording its largest decline since April. The 10-year Treasury yield rebounded above the 4% mark, and the 30-year Treasury yield touched 4.42%, the highest level since July 30.

In last Friday's US Treasury options trading, several notable put option trades were attempting to bet that the yield curve would become steeper. A put option on the 10-year Treasury is targeting a yield of around 4.5% before the November 22 expiration date, and several large trades are hoping to reach around 4.75% at that time.

Kit Juckes of BNP Paribas wrote in a report: "The market is clearly uncertain about the outcome of the next few Federal Reserve decisions, and the rapid rise of nearly 50 basis points in the 10-year US Treasury yield since mid-September indicates that the market is increasingly certain that the US economy will not 'hard land'. This suggests a view that the possibility of a 'no landing' is as likely as a 'soft landing', which raises concerns that if fiscal tightening measures do not appear, inflationary risks may re-emerge."

Investment allocation requires careful consideration

Against this backdrop, many industry insiders seem to find it difficult to decide where to deploy cash in the world's largest bond market, whether on the short end or the long end, making the relatively less risky middle part of the curve a safe haven in the eyes of some investors.To mitigate vulnerabilities under economic recovery, potential fiscal shocks, or turbulence from the U.S. elections, asset management companies, including giants such as BlackRock, PIMCO, and UBS Global Wealth Management, currently advocate for the purchase of five-year bonds. This is because, compared to shorter or longer-term peers, five-year bonds are less sensitive to such risks.

Solita Marcelli, Chief Investment Officer for the Americas at UBS Global Wealth Management, suggests investing in medium-term bonds, such as government bonds and investment-grade corporate bonds with a maturity of about five years. Marcelli stated, "We continue to advise investors to prepare for a low-interest-rate environment, allocating excess cash, money market holdings, and maturing term deposits to assets that can provide more enduring income."

The U.S. bond market will be closed on Monday due to Columbus Day. However, in the coming weeks, the bond market will clearly still have significant room for volatility — not only related to the U.S. elections.

As investors await the quarterly bond issuance from the U.S. Treasury (expected to remain stable), the next monthly non-farm employment report, and the Federal Reserve's interest rate decision on November 7th, some industry insiders have predicted that market volatility could continue for several weeks.

Citadel Securities has warned its clients to prepare for the so-called "significant future fluctuations" in the bond market. The company anticipates that the Federal Reserve will only cut rates by another 25 basis points in 2024.

David Rogal, Portfolio Manager of BlackRock's Fundamental Fixed Income, also stated, "As the election enters the window of option play, implied volatility will rise." The company prefers medium-term Treasury bonds because it believes that as long as inflation cools, the Federal Reserve will readjust the policy cycle, pushing policy rates from 5% towards a range of 3.5%-4%.

Of course, with the so-called "anchor of global asset pricing" returning to a high of about 4.1%, the current bond market sell-off is also leading some long-term investors to believe that the "buying area" has arrived.

Roger Hallam, Global Head of Interest Rates at Vanguard Group, said in an interview, "Our core view is that the economy will indeed slow down next year due to the Federal Reserve's policy remaining restrictive. This means that for the company, when the 10-year yield exceeds 4%, there is an opportunity to start extending the duration of our investment portfolio, considering the downward trend in growth for next year."

He added that this will allow the company to gradually "shift towards a greater emphasis on bonds."