The likelihood of the Federal Reserve cutting interest rates in September is growing, and the bond market has already taken a lead. The U.S. Treasury market is on track to record a monthly increase for three consecutive months this month, which would be the longest uptrend in three years.

On July 29th Eastern Time, U.S. Treasury bonds as a whole rose, with yields for most maturities falling back. The 2-year U.S. Treasury bond yield increased by 1.6 basis points to 4.41%, the 5-year U.S. Treasury bond yield fell by 0.6 basis points to 4.079%, the 10-year U.S. Treasury bond yield fell by 2.3 basis points to 4.177%, and the 30-year U.S. Treasury bond yield fell by 2.9 basis points to 4.427%.

Due to market expectations that the Federal Reserve will hint at an upcoming interest rate cut cycle at this week's meeting, U.S. Treasury bond prices have continued to rise recently. As of July 29th, the Bloomberg U.S. Treasury Bond Index rose by 1.3% in July, with a return rate of about 3.9% since the end of April.

However, the rise in U.S. Treasury bonds is largely attributed to the increase earlier in July. Before the release of the Federal Reserve's interest rate decision and non-farm data, the market sentiment is cautious, and investors are closely monitoring the subtle signs of the monetary policy path.

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Why are U.S. Treasury yields falling?

The recent continuous rise in U.S. Treasury bonds, the decline in yields, and the warming expectations of interest rate cuts are closely related.

Lu Zhe, Chief Economist of Founder Securities and Deputy Director of the Research Institute, told 21st Century Economic Report reporters that since July, the continuous warming of interest rate cut expectations has driven the overall downward trend of U.S. Treasury bond yields, with short-term interest rates falling more than long-term rates, and the curve significantly steepening. The June non-farm and CPI data released in July showed a cooling of employment demand and a comprehensive improvement in inflation, driving interest rate cut expectations to rise rapidly. The market's expectation for the probability of a rate cut in September quickly rose from around 70% to 100%, with a full-year rate cut of 2.64 times/66 basis points.

As expectations for a Federal Reserve rate cut warm up, short-term bond yields fall more. Lu Zhe analyzed that short-term yields mainly reflect changes in interest rate cut expectations. Compared with last month, the entire U.S. Treasury yield curve saw the most significant decline in the 2-year term, followed by the 1-year, 3-year, and 5-year terms, meaning the front end of the curve moved down overall. The 10-year U.S. Treasury bond rate is more affected by recent U.S. election risks and the "Trump trade," with risks trending upwards and limited declines. Trump's policy stance advocates for tax cuts and encourages reindustrialization domestically, while imposing tariffs and expelling immigrants externally. These all help to stimulate domestic demand, raise long-term inflation expectations, and drive long-term yields upwards. Therefore, in comparison, short and medium-term yields fall more.

In addition, yields for specific maturities are also affected by the supply and demand conditions reflected in Treasury auctions. Last week, $44 billion worth of 7-year U.S. Treasury bonds were auctioned, with good results. The winning interest rate was 4.162%, higher than the pre-issuance interest rate of 4.166%; the subscription multiple was 2.64 times, higher than the previous value of 2.58 times; the primary dealer winning ratio was 8.9%, the lowest in a year, indicating strong real buyer demand, which is conducive to a decline in yields.

How will the bond market evolve in the future? Lu Zhe analyzed that in the short term, it is expected that the July FOMC meeting of the Federal Reserve will be generally dovish, and until the end of August, it is expected that the interest rate cut trade will still have a short but limited window period, with more room for short-term bonds to decline than long-term bonds. It is necessary to be vigilant about the highly uncertain election risks that disturb the market, with the impact on long-term U.S. Treasury bond rates trending upwards. In the medium term, before the election in the fourth quarter, the 10-year U.S. Treasury bond rate is likely to maintain a fluctuating trend but with a narrower range, expected to fluctuate widely in the range of 3.9% to 4.3%. Starting in the fourth quarter, the market will face many risks from the U.S. election, inflation rebound, debt ceiling crisis, and other factors, with higher upward risks for U.S. Treasury bond rates.The Timing of Interest Rate Cuts Becomes Gradually Clear

From various signs, the timing of the Federal Reserve's first interest rate cut in September is becoming increasingly clear.

The Federal Reserve has always been weighing the pros and cons between cutting interest rates too early and waiting too long, and now officials are increasingly worried that waiting too long could undermine a soft landing. Federal Reserve Chairman Powell frankly stated in July during a congressional hearing that high inflation is not the only risk the Federal Reserve is currently facing. The latest labor market data has sent a fairly clear signal that labor market conditions have cooled significantly compared to two years ago. "If I hadn't seen the data from the past two months, I wouldn't say that."

Lu Zhe analyzed that the Federal Reserve officials' statements on the expectation of interest rate cuts are noticeably biased towards easing. For example, Powell recently said that more progress was made in inflation in the second quarter, and it is not necessary to wait for inflation to drop to the Federal Reserve's 2% target before cutting interest rates. Federal Reserve Governor and one of the most influential officials, Waller, shifted his previous hawkish stance and took a more open attitude towards interest rate cuts, stating that if the inflation data for the next two months is as mild as in May-June, interest rates will be cut in September.

At 2 a.m. Beijing time on August 1, the Federal Reserve will announce the July interest rate decision. What are the highlights of this meeting? Will the Federal Reserve clearly release a signal for a rate cut in September?

In Lu Zhe's view, the market's pricing of the expectation of interest rate cuts is already very saturated, and a September rate cut is almost a foregone conclusion. Therefore, the main focus of this meeting is to what extent Powell will affirm or undermine the current very optimistic expectation of interest rate cuts.

Matt Weller, Global Head of Research at嘉盛 Group, told reporters that inflation is close to the Federal Reserve's target, and the risks in the labor market are increasing. Even if the Federal Reserve does not take action, real interest rates are also becoming increasingly tight, which is a sufficient reason to consider an immediate interest rate cut. However, in the past few months, the Federal Reserve has been paving the way for an interest rate cut cycle in September, so it is basically impossible to take action ahead of schedule this week. It is expected that the Federal Reserve will maintain interest rates unchanged this time and use the monetary policy statement and press conference to prepare for the interest rate cut in September, but it may not commit to a rate cut in advance.

Powell may open the door for a September rate cut, but may not explicitly promise to take any action. Former Federal Reserve Senior Advisor William English also said that if there are no major issues with new news around inflation between now and September, then Federal Reserve officials can say: "Okay, now we are sure that we are on the right track, and we are going to start cutting interest rates."

Under the current fundamentals and market expectations, Lu Zhe expects the meeting to be generally dovish, and Powell may give a more open guidance for a September rate cut while emphasizing that subsequent rate cut decisions still depend on the data. Specifically, the July meeting statement may marginally adjust the description of inflation, such as changing "remaining high" to "moderate". Powell's speech at the press conference may be dovish, and there may be similar remarks: "Recent economic and inflation data have given the Federal Reserve more confidence to start cutting interest rates. If the data between the July-September FOMC meetings can continue to confirm this, then a preemptive interest rate cut will become appropriate, but the FOMC's decision still depends on the economic data it sees." Of course, the non-farm and CPI data in July-August still have a significant impact on whether a rate cut can be made in September, and a September rate cut is not a 100% certain event.

In addition to paying attention to the "first cut" signal,If subsequent economic data do not deviate significantly from the current trajectory, there is little doubt that the Federal Reserve will cut interest rates in September, and the signals beyond the first cut require more attention.

Weller stated that the probability of the Federal Reserve cutting interest rates in September is higher. At this week's meeting, Powell will set the conditions for easing policies. The inflation rate needs to continue moving towards the target. However, the more important clue is the magnitude of rate cuts entering 2025. Currently, the interest rate futures market has already priced in more than five rate cuts for next year.

The market's expectations for the future are not without risks. It is necessary to be vigilant, as although significant progress has been made in the battle against inflation, it is still too early to claim victory. Data released by the U.S. Department of Commerce's Bureau of Economic Analysis shows that the PCE price index increased by 0.1% month-on-month in June, and rose by 2.5% year-on-year, with the previous value being 2.6%; the more closely watched core PCE price index increased by 0.2% month-on-month, and rose by 2.6% year-on-year, which is basically in line with expectations.

Lu Zhe analyzed for reporters that, according to the Taylor Rule guidance, the current combination of a 4.1% unemployment rate and a 2.6% year-on-year increase in the core PCE price index corresponds to a policy interest rate of 5.13%, which is lower than the current 5.5%. The Federal Reserve indeed has room to cut interest rates this year. However, the resilience of the U.S. economy and the slow rate of inflation decline also mean that although there may be a precautionary rate cut in September, the market's current expectation of 2.7 rate cuts for the year and a cumulative 5-6 rate cuts by the fourth quarter of 2025 still carries the risk of adjustment.

Some also worry that the Federal Reserve is trying to avoid getting involved in the increasingly fierce competition of the U.S. elections. The market expects the Federal Reserve to start a rate-cutting cycle in September this year, at which time there will be less than two months left before the U.S. presidential election, adding a touch of complexity to the Federal Reserve's monetary policy.

Nobel Prize-winning economist Paul Krugman analyzed that, considering the lag effect of monetary policy on the real economy, the Federal Reserve's rate cut in September should have little impact on the election. However, consumers' views on the economy do not entirely follow traditional variables. "If the Federal Reserve cuts rates, it is a prestigious voice saying, 'We are no longer worried about inflation,' which could affect the course of events."

Amid the current whirlpool of U.S. politics, Powell is struggling to defend the independence of the Federal Reserve. Powell has repeatedly emphasized the importance of the Federal Reserve's independence in setting interest rates and will continue to make decisions based on data. Powell believes that central bank independence leads to good outcomes and should be maintained.

More importantly, how the Federal Reserve balances fighting inflation and stabilizing the economy, the authorities cannot predict the future, and the prospects for monetary policy are still shrouded in fog, only able to move forward by feeling the data. In Powell's view, the Federal Reserve is now facing a dilemma. Cutting rates too early may reignite the economy and lead to inflation above the target level, while keeping rates too high may cause the labor market to cool down excessively. "For a long time, the main risk we have faced is the inability to achieve the inflation target. Now the risks on both sides are becoming balanced, and we are very clear about the dual risks we are facing now."