The U.S. bond market sends positive signals, focus on two major risk events in the second half of the year!

U.S. government debt ended its longest monthly rally in three years on the last trading day of July, thanks to easing supply concerns and widespread expectations in the market for a Fed rate cut cycle to begin in a few months.

On Wednesday, U.S. Treasuries recorded a third consecutive month of gains, marking the longest monthly rally since the four-month streak that ended in July 2021. The current rally has pushed yields on 2-year and 10-year U.S. Treasuries down by over half a percentage point from the year-to-date high set at the end of April. At the same time, the rate on the longest-dated 30-year U.S. Treasury bond has dropped by 44.9 basis points during the same period.

Analysts say that this rally reflects growing optimism about the U.S. having passed the most severe inflation period in over 40 years, increasing the attractiveness of government debt.

The easing of inflation concerns is also reflected in the decline of yields on 5-year and 10-year U.S. Treasury Inflation-Protected Securities (TIPS). According to Tradeweb data, as of Wednesday, both yields were below 2% and at their lowest levels since early April and late March. The 5-year TIPS rate has remained steady below 2% since July 10. Meanwhile, the 30-year TIPS rate stood at 2.149% at 3 p.m. Eastern Time, the lowest level in nearly two weeks.

Will Compernolle, macro strategist at New York FHN Financial, said, "Ultimately, this is due to two consecutive months of strong CPI data. People are increasingly believing that the worst is behind us. And when inflation is low, the value of U.S. government debt is higher, meaning more Fed easing. People are regaining confidence from the beginning of the year."

Interestingly, the bond market dynamics are taking on a shape that was previously associated with negative economic events.

The drop in short-term bond yields is greater than that of long-term bonds, leading to a narrowing of the spread between the two and a steepening yield curve. This steepening after a long-term inversion is often seen as a signal that the bond market is increasingly convinced that a recession is imminent and that the Fed will need to cut rates multiple times.

What remains to be seen for the rest of the year is whether the Fed can achieve a soft landing and avoid a recession, or if economic growth and inflation will move in the opposite direction. Most federal funds futures traders expect a total of three rate cuts by the end of the year, each cut being 25 basis points.

Bond market traders are also watching developments leading up to the presidential election on November 5. At the beginning of the month, they were concerned that the U.S. election would be the biggest risk in the second half of the year, considering that both major parties may not constrain fiscal policy. However, after two statements from the Treasury Department earlier this week helped alleviate market concerns about supply, this notion has changed.

On Monday, the Treasury Department significantly lowered its borrowing estimate for the third quarter to $740 billion, a reduction of over $100 billion from the estimate three months ago. On Wednesday, the Treasury Department stated that it does not plan to increase the auction size of nominal fixed-rate or floating-rate notes for at least the next few quarters.

Compernolle said over the phone, "The fiscal trajectory for the coming years has been a concern, with expectations that the size of fixed-rate auctions would increase. This morning we learned that these increases will happen further down the line, giving long-term debt investors some relief "

He stated that the main focus of the bond market for the rest of this year will be on the "Federal Reserve and politics." Traders will react more strongly to the progress of the November 5th election, while also waiting to see if the Federal Reserve can meet traders' expectations of three 25 basis point rate cuts.

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