Powell signals rate cuts as soon as next month, causing government bonds to rally

U.S. government bonds went up Friday after Fed Chair Jerome Powell said the central bank might cut interest rates as soon as next month. But with important inflation and jobs data still to come, markets could shift again before the Fed’s September 17 meeting.

Powell pointed to ending the eight-month pause in easing, saying labor-market risks may “warrant adjusting our policy stance.” Treasuries rallied, and the gap between short and long maturities widened by the most in four years.

Markets stopped short of calling a cut a certainty. Futures put the odds of a quarter-point move in September near 80%. Yields, though lower, did not break this month’s lows as traders waited for employment and inflation reports due before the decision.

The move showed the Fed weighing a weakening job market against the risk that President Donald Trump’s tariffs could push inflation up again.

All eyes on inflation gauge and bond auctions

The Fed’s preferred inflation gauge may show firm pressures, and Treasury auctions of two-, five-, and seven-year notes will test demand.

“Powell solidifies market expectations of a cut in September,” said Gregory Peters, co-chief investment officer at PGIM Fixed Income.

“It’s less about whether the move comes in September or October. We don’t know what the next six months will look like. It’s still going to be an environment of mixed data, keeping the bond market on edge.”

Short-dated yields led Friday’s move, as per Bloomberg. The two-year note fell 10 basis points to 3.7%, near its early-August low after a weak jobs report. In swaps, traders priced two quarter-point reductions by year-end, with a small chance of a third, as reported by Cryptopolitan.

That pricing “is the appropriate reaction,” said John Briggs, head of U.S. rates strategy at Nataxis North America, but “anything further than two-and-a-half cuts being priced before we get to payrolls is too aggressive.”

The shift fueled curve-steepening wagers that short rates will drop faster than long ones as easier policy supports growth, and pushed the spread between five- and 30-year yields to the widest since 2021.

Investors choose short-term bonds over long-term ones

Investors remain more comfortable in shorter maturities, which could rally when the Fed starts easing. Longer Treasuries draw less demand because they are more exposed to future inflation and the swelling deficit.

The stance has also served as protection against pressure on the Fed. Trump has criticized Powell and threatened to fire Governor Lisa Cook over mortgage-fraud allegations. Cook said she would not bow to pressure to step down.

Such attacks on the central bank’s independence unsettle markets.

“The front end now has Chair Powell on its side, and yields there should stay down,” said Padhraic Garvey of ING, who oversees research in the Americas. “The long end is not loving this,” he added, saying it “likely reflects a suspicion that the Fed could be taking risks with inflation here.”

Another risk is cutting while inflation is sticky — and may rise — which could cap how far 10-year and longer yields fall. Late 2024 offers a reminder: longer yields climbed even as the Fed cut by a full percentage point.

Market-based inflation expectations also edged up Friday.

“If we do have a Fed that’s cutting in this environment where inflation is still a far cry from their target, we think the market should show more signs of this inflation target moving higher and becoming unanchored,” said Meghan Swiber, a rates strategist at Bank of America.

Upside surprises in growth or prices could trigger another selloff before the meeting.

“There’s a long way between now and September 17th,” said Michael Arone, who serves as chief investment strategist at State Street Investment Management.

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