Expectations are high for the Fed to cut interest rates next week! Rapid changes in the US bond market

As the calls for the Federal Reserve to start cutting interest rates as early as next week grow louder, the yield curve of U.S. Treasuries has steepened sharply.

On Wednesday, the yield on the two-year U.S. Treasury, sensitive to policy changes, fell by three basis points, while the 10-year Treasury yield rose by about the same magnitude. This has narrowed the gap between these yields to about 14 basis points, the smallest difference since October 2023.

This indicates that investors believe the Federal Reserve may cut interest rates faster and more aggressively than previously expected. Swap traders still believe that the rate cuts this year will exceed 2 times by 25 basis points, with the first rate cut possibly in September.

But as the Federal Reserve is set to announce its latest rate decision next week, the pressure to cut rates is mounting. Former New York Fed President Dudley wrote in an opinion column that policymakers should cut rates at the July meeting.

Zachary Griffiths, Senior Fixed Income Strategist at CreditSights, said, "The front end of the market has been rallying because the Fed is expected to cut rates earlier and more aggressively than previously priced in by the market."

This trend indicates that the steepening of the yield curve is resuming, a bet favored by investors expecting Trump to win the presidential election in November.

On Wednesday, the 30-year U.S. Treasury yield rose by 7 basis points to 4.55%, the highest level since July 5th. This is the highest level since May 2023.

The steepening of the yield curve reflects "the market's 100% probability of a rate cut in September, stock selling, and repositioning of election news," said George Catrambone, Head of DWS Americas Fixed Income.

He said, after the Fed's July meeting, the focus will shift to a series of data reports to look for substantial evidence of weakness, "which could reignite doubts about a soft landing, perhaps the Fed will lag behind the curve and miss the opportunity to cut rates in July".

Similarly, Jan Hatzius, Chief Economist at Goldman Sachs, released a research report on the 15th of this month suggesting that a rate cut by the end of July is reasonable. Given that the market currently expects the Fed to act no earlier than September, if these economists are proven right, it would be the biggest surprise in the global financial markets this summer.

Wednesday's economic data showed a renewed contraction in U.S. manufacturing and an unexpected decline in U.S. new home sales. Hours later, a $700 billion five-year U.S. Treasury was auctioned at a yield of 4.121%, higher than the 4.110% trading level at the end of the auction. This result was considered average compared to the record $690 billion demand for two-year U.S. Treasuries on Tuesday. Changes in long-term yields led the U.S. Treasury to not accept any bids from dealers in Wednesday's debt buyback operation