Previously, against the backdrop of U.S. debt investors pricing in an early Federal Reserve rate cut, the U.S. debt market recorded gains for five consecutive months. However, this situation reversed in October.

A client survey by JPMorgan revealed that in the first week of October, the institution's clients held a net short position in U.S. debt for the first time since April 2023, with the total short position reaching the highest level since February 2023. Subsequently, the release of weak labor market data and higher-than-expected inflation data led bond traders to reduce their bets on further rate cuts by the Federal Reserve within the year, with bearish sentiment continuing to accumulate. Against this backdrop, the five-year U.S. debt, which is relatively less sensitive to interest rate fluctuations, has become more favored by bond investors compared to long-term and short-term debt. In addition to the market trend of U.S. debt itself, the U.S. repurchase rate corridor encountered problems again at the beginning of October, seemingly indicating the risk of a liquidity shock to the market from a new round of U.S. debt issuance.

Volatility is likely to intensify.

Last week, as U.S. debt bears gathered, the Bloomberg U.S. Bond Index recorded the largest single-week decline since April. The yield on the 10-year U.S. debt rebounded to above 4%, hovering around 4.1% at noon today. The yield on the 30-year U.S. debt reached the highest level since July 30.

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The main change in the recent trend of U.S. debt is that investors expect the Federal Reserve to slow down the pace of rate cuts for the remainder of the year. According to the CME Group's FedWatch Tool, traders currently estimate an 86.5% chance of a 25 basis point rate cut in November, a 13.5% chance of no rate cut, and a 0% chance of a 50 basis point rate cut. The latest pricing in the interest rate swap market shows that the Federal Reserve will cut rates by approximately 45 basis points in total over the remaining two meetings of the year. Before the release of the non-farm employment data, this expectation was once as high as about 66 basis points, and it still reached over 50 basis points before the release of the inflation data. Some option contracts have begun to bet that the Federal Reserve will only cut rates once more within the year, with a single cut of 25 basis points, and some extreme contracts even bet that the Federal Reserve will pause rate cuts at the beginning of next year. Some put options on the 10-year U.S. debt expiring on November 22 even bet that the yield will rise to about 4.5% before the expiration date.

Kevin Flanagan, Head of Fixed Income Strategy at Wisdom Tree, an asset management company, said, "The recent economic data, especially the employment report, does not support the rationale for U.S. debt to continue to rise." Patrick Armstrong, Chief Investment Officer at Plurimi Wealth, a wealth management institution, also said, "The U.S. debt market's pricing of rate cuts was indeed a bit ahead of schedule, and inflation may become a problem again next year."

Federal Reserve officials have also recently made frequent statements to "cool down" rate cut expectations. St. Louis Fed President Musalayem previously stated that further rate cuts should be gradual; Atlanta Fed President Bostic said that the Federal Reserve should continue to focus on the inflation rate; Federal Reserve Governor Kugeler warned that if the progress of a significant downward trend in inflation stagnates, it may be necessary to slow down the pace of rate cuts. The latest statement came from Federal Reserve Governor Waller. On October 14, he cited recently released reports on employment, inflation, gross domestic product (GDP), and income, saying, "These data suggest that the economic slowdown may not be as significant as expected. Although we do not want to overreact or overinterpret these data, the overall data indicate that the Federal Reserve should be more cautious in the pace of rate cuts than at the September meeting."

In addition, the ICE BofA Move Index, which measures the expected volatility of U.S. debt, has also risen to the highest level since January of this year, implying that investors expect the U.S. debt market to face greater volatility. David Rogal, a portfolio manager in the fixed income department of BlackRock, said, "As the U.S. election enters the option trading window period, the implied volatility of U.S. debt will continue to rise." The institution predicts that the Federal Reserve's current rate cut cycle will ultimately adjust the policy rate from 5% to 3.5% to 4%. The election results will determine U.S. fiscal policy, thereby affecting investor expectations.

The five-year bond may enter the "sweet spot" position.

Amid the "cloudy and foggy" prospects of Federal Reserve rate cuts and the results of the U.S. election, many institutions, including PIMCO, BlackRock, and UBS Global Wealth Management, have shown a preference for five-year bonds. On the one hand, five-year U.S. debt is less sensitive to interest rate risk. On the other hand, investor concerns that the rising U.S. deficit will cause trouble for long-term U.S. debt have also helped to establish the "sweet spot" position of five-year U.S. debt.Andrew Balls, Chief Investment Officer of Global Fixed Income at PineBridge Investments, told Yicai Global that the US economy seems to be on track for a rare soft landing, where growth and inflation moderate without falling into recession. However, he cautioned that this baseline scenario also carries risks, such as the upcoming US elections and their impact on tariffs, trade, fiscal policy, inflation, and economic growth. High budget deficits may persist, thereby limiting the possibility of further fiscal stimulus and increasing economic risks.

"In terms of geopolitical risks, the US election remains a significant source of uncertainty. Regardless of who wins, the direction of tariffs is clear. However, if former President Trump wins a second term, the likelihood of introducing globally disruptive trade policies would be higher. Monetary policymakers must pay attention at that time, as although a decline in real income poses a downside risk to economic growth, a short-term increase in inflation (because the additional costs of tariffs will be passed on to consumers) may lead to rising inflation expectations," he said. At the same time, he analyzed for Yicai Global, "Regardless of which party wins, the US deficit will be the biggest loser. The provisions of the 2017 Tax Cuts and Jobs Act are about to expire, and tax reform will become a focus for the US government next year. We do not expect much additional fiscal stimulus or fiscal consolidation. Before any additional policy changes are introduced, the annual deficit may remain high, at 6% to 7% of GDP. These contexts reinforce our view that the US yield curve will steepen. Moreover, bond yields are attractive, both in nominal terms and after adjusting for inflation, with the five-year segment being particularly attractive. High government deficits may push up long-term bond yields over time."

Solita Marcelli, Chief Investment Officer for the Americas at UBS Global Wealth Management, also prefers medium-term bonds, such as five-year US Treasury bonds. She said, "We continue to advise investors to prepare for a low-interest-rate environment by investing excess cash, money market assets, and maturing term deposits into assets that can provide more sustainable income."

Risk of Liquidity Shock?

The market is also concerned whether a new round of US Treasury issuance, coupled with the ongoing Fed's balance sheet reduction process, will once again bring liquidity shocks to the market.

This concern is not unfounded. At the beginning of October, the Federal Reserve's repurchase rate corridor, a pillar of the US financial system, broke down, with the general collateral rate once surging to nearly 40 basis points higher than the reverse repo rate. The reverse repo rate is the upper limit of various overnight rates of the Federal Reserve. Although the breakdown only lasted a few days before the general collateral rate fell back below the reverse repo rate, Mark Cabana, a US bank rate strategist, warned that this foretells that the US may soon face another repurchase market crisis and liquidity shock, especially if the US Treasury continues to issue US Treasury bonds when the next crisis emerges.

Cabana even stated that the current situation is very similar to the collapse of the US repurchase market before 2019. At that time, the Federal Reserve was also advancing the balance sheet reduction (QE) process, and the overnight rate of the repurchase market soared, causing severe short-term liquidity risks in the money market. To address this risk, in March 2020, the Federal Reserve announced the monetization of bond ETFs, equivalent to injecting a large amount of liquidity into the market. Before the Federal Reserve announced the measures, Cabana predicted that the Federal Reserve would introduce "wartime measures" to take over the market.

This time, since early September, due to factors such as the increase in the Treasury's cash (TGA) balance at the end of the quarter, the Federal Reserve's rate cut leading to a decrease in the balance of the Bank Term Funding Program (BTFP), and banks needing to beautify their accounts at the end of the third quarter, about $260 billion in reserves flowed out of the US banking system, pushing the repurchase rate to the highest level since the last liquidity crisis in the US caused by the COVID-19 pandemic.

Cabana added that currently, the sensitivity of reserves to the Secured Overnight Financing Rate (SOFR) has increased, indicating that the current reserves may be approaching the minimum comfortable level of reserves (LCLoR). Theoretically, when reserves fall below the LCLoR, market liquidity is prone to dry up. Cabana and other Federal Reserve experts believe that the LCLoR is about $3 trillion to $3.25 trillion. With the Federal Reserve still reducing its balance sheet and a new round of US Treasury issuance imminent, reserves may fall below $3 trillion, and the market may face another liquidity crisis.