Fear of 'R' Boosts Bonds... US 'Big Cut' Expectations Rise

As the U.S. stock market continues to plunge amid concerns over a recession and the escalation of conflicts in the Middle East, bonds have shown continuous strength with market interest rates declining. The expectation that the U.S. Federal Reserve (Fed) and the Bank of Korea will implement larger-than-expected rate cuts (big cuts) sooner if the recession deepens has played a role.

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed) [Image source=Reuters Yonhap News]

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According to the bond market on the 6th, Treasury bond yields sharply declined on the 5th, hitting new yearly lows. The final yield on the 3-year Treasury bond fell 13.3 basis points (bp, 1bp=0.01%) from the previous session to 2.806%. This is the lowest level in about two years and four months since April 1, 2022 (2.784%). The 10-year maturity yield dropped 9.8bp to 2.878%, marking the lowest point since March 2022. This figure is about 70bp lower than the Bank of Korea’s base rate of 3.50%. A decline in market interest rates means a rise in bond prices. Thus, bond prices surged even as stock prices underwent a sharp correction.

Significant buying by foreigners and institutions also flowed into the Treasury bond futures market. On the 5th, the 3-year Treasury bond futures (KTB) rose 39 points (ticks) to 106.30. Foreign investors net bought 17,318 contracts, while securities firms net sold 26,206 contracts. The 10-year Treasury bond futures (LKTB) increased by 81 ticks to 118.26. Banks and foreigners net bought 1,299 and 524 contracts respectively, while securities firms net sold 2,459 contracts. The 30-year Treasury bond futures rose 2.10 points to 144.28.

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The reason the bond market is strong amid the stock market plunge is the growing expectation of a big cut of more than 50bp in interest rates. On the 2nd, the U.S. unemployment rate rose to 4.3%, spreading fears of a recession in the market. If the U.S. accelerates the timing and magnitude of rate cuts in response to economic conditions, expectations have grown that the Bank of Korea could also speed up its rate cuts. A bond market insider said, "Poor U.S. employment data triggered concerns about a recession," adding, "Demand betting on the possibility of the U.S. making a big cut sooner than expected surged."

Calls for policy rate cuts are also emerging in various quarters. Jeremy Siegel, a renowned investment strategist on Wall Street and professor emeritus at the Wharton School of the University of Pennsylvania, stated in an interview with CNBC the previous day, "The U.S. base rate should currently be between 3.5% and 4.0%," and argued, "The Fed should urgently cut rates by 75bp and further reduce by 75bp in September; this is the minimum action." Yoon Sang-hyun, a member of the People Power Party, wrote on social media, "The Bank of Korea should cut rates twice by 25bp each from August to October," adding, "We must not miss the timing of rate cuts like the U.S."

Concerns about interest rate polarization are also emerging amid the decline in market interest rates. As the recession materializes, investment demand is concentrating on stable bonds such as Treasury bonds, public bonds, and financial bonds, leading to a widening interest rate gap between high-quality bonds and relatively lower credit-rated non-investment grade bonds. A corporate bond market insider said, "Along with the sharp stock price drop, funds flowing into high-yield corporate bonds have also significantly decreased," and predicted, "If R fears expand, investment demand for non-investment grade bonds is likely to tighten."

It is uncertain how long the bond market’s strength will last. Since the recent pace of market interest rate decline has been excessively rapid, there is a possibility that the falling rates may partially rebound depending on U.S. economic indicators and the Fed’s stance. Although the U.S. unemployment rate has risen slightly, it is not at an absolutely high level to warrant recession fears, and other economic indicators also need to be examined further. The U.S. Institute for Supply Management (ISM) announced on the previous day that the July Services Purchasing Managers’ Index (PMI) recorded 51.4, indicating a shift to ‘expansion.’ A PMI above 50 signals economic expansion, while below 50 indicates contraction.

Ahn Ye-ha, a bond strategy analyst at Kiwoom Securities, said, "After the employment data release, the Chicago Fed president tried to temper expectations for a 50bp cut before September by saying ‘we will not overreact to a single indicator,’" and forecasted, "Considering that current recession concerns are somewhat excessive and the Fed’s rate cut pace will not suddenly accelerate, there will be a moderation in the speed of further market interest rate declines."

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