Overnight, the stock and bond markets turned upside down! Non-farm payrolls ignited expectations for interest rate cuts to resurface, and the "bull market steepens" swept Wall Street

Just as global U.S. Treasury investors began to doubt one of their long-favored bond market strategies, it unexpectedly made a comeback.

Last Friday, due to the surprisingly weak U.S. non-farm payroll report, market skepticism about U.S. economic growth momentum increased, driving a comprehensive recovery in interest rate cut expectations. After a month-long painful decline in bonds, the prices of U.S. Treasuries across all maturities finally experienced a long-awaited surge, triggering almost frenzied buying.

This non-farm payroll report not only revealed a surprising increase of only 73,000 jobs in July but also unexpectedly revised down the employment data for May and June, cutting a total of up to 258,000 jobs, with a downward revision of an unprecedented 90%—the term "halved" can no longer describe it; some seasoned analysts joked that this revision could be termed "amputation below the eyebrows."

As a result, this non-farm data largely prompted traders to bet heavily on the Federal Reserve cutting interest rates: the pricing in the interest rate futures market shows that traders are betting heavily on the restart of the Fed's rate cut cycle, with the probability of a rate cut next month reaching as high as 84%—up from less than 40% before the non-farm report—and betting on at least two rate cuts by the end of the year, even betting on consecutive cuts of 25 basis points in September and October, along with a cumulative 75 basis points cut by the end of the year.

In response to this weak employment report, Rick Rieder, Chief Investment Officer of Global Fixed Income at BlackRock, stated: "Today's report provides important evidence for the Fed to adjust rates in September, so the only question is how much the adjustment will be. The likelihood of a 50 basis point cut in September is continuously increasing—if the weakness in the labor market worsens or if new jobs continue to fall below the 100,000 mark."

"We are now facing a completely different labor market backdrop," said Kevin Flanagan, Head of Fixed Income Strategy at WisdomTree. "The downward revision of 250,000 jobs in the non-farm data is enough to rewrite the entire market narrative."

When bond market traders believe that the federal funds rate will decline in the future, they will immediately map this information to the entire yield curve: short-term yields are directly anchored to the policy path, while medium- and long-term yields equal the weighted average of future short-term rates plus a risk premium.

The reason U.S. Treasury prices surge when "the Fed cuts rates, or expectations for Fed rate cuts heat up" can be summarized as a sharp decline in cash flow discount rates + downward shift in expected paths + increased holding yields + "institutional equity-debt asset-liability balance rebalancing."

Therefore, their anticipated "low rates—low discount rates" means that the present value of both bond coupons/principal immediately rises (prices increase); at the same time, lower financing costs and a steepening curve bring higher positive holding yields and reinvestment returns, further attracting incremental buying. The combination of these four forces often explodes instantaneously under the catalyst of weak data (such as the mere addition of 73,000 non-farm jobs in July, with the previous two months being significantly revised down), triggering an instant expansion of institutional bullish forces in U.S. Treasuries, forming a classic "U.S. Treasury bull market steepening" trend where "painful trades" reverse into significant gains The so-called "bull steepening" strategy in the U.S. Treasury market refers to a significant decline in short-term yields (such as those for 2-year bonds and below) due to expectations of interest rate cuts, while long-term yields (such as those for 10-year to 30-year bonds) experience a limited decline but overall trend downward. This leads to a rapid widening of the long-short yield spread, making the entire yield curve steeper in the context of a bull market for U.S. Treasury prices characterized by "price increases/yield declines."

Weak Employment Report Reignites Steepening of U.S. Treasury Yield Curve

The shock effect from labor market data has triggered a widespread increase across various maturities of government bonds, but the strong performance of short-term U.S. Treasuries (2 years and below) is particularly notable. The yield on the most interest-sensitive 2-year U.S. Treasury bond fell by more than 25 basis points in a single day, marking the largest decline since December 2023—U.S. Treasury prices and yields move inversely, so a drop in yield signifies a substantial rebound in price.

Although the price increase of long-term U.S. Treasuries (10 years and above) is not as pronounced as that of short-term Treasuries, it has also shown a rare overall recovery, prompting a collective return of bulls to the U.S. Treasury market. This has further widened the yield spread between short and long maturities, bringing considerable profits to investors betting on the so-called "steepening of the yield curve" strategy.

It is worth noting that this strategy has been largely stagnant since April when the aggressive tariff policies of the Trump administration severely impacted the bond market, and it suffered losses for most of the time until July due to ongoing expectations of interest rate cuts, forcing many U.S. Treasury bulls, especially those in short-term bonds, to unwind their positions. For institutional investors, the key pain point is the high cost of financing: to maintain this position, the yield curve needs to continue moving downward and steepening to offset holding costs. However, ambiguous economic data, unclear tariff prospects, and occasional sharp turns in interest rate cut expectations have left the market lacking catalysts.

For those traders who maintained their U.S. Treasury positions and even increased their holdings during the lowest period for U.S. Treasuries in July, Friday was a moment of vindication and may signal potential further gains in the near future.

"We remain optimistic about the 'bull steepening' trade based on the recovery of U.S. Treasury prices, so we are pleased with this price trend," said Mark Dowding, Chief Investment Officer of Fixed Income at BlueBay, a subsidiary of asset management giant RBC Global Asset Management, who is betting on the strong profit opportunities brought by the widening yield spread between 2-year and 30-year U.S. Treasuries.

On Friday, this yield spread recorded the largest single-day increase since April 10, as bond market traders rushed to rebuild positions that would benefit from a steepening yield curve under the basic scenario of Federal Reserve interest rate cuts. On Monday morning in New York, the trading volume of U.S. Treasury futures reached about three times the usual level, with trading in ultra-short contracts linked to Federal Reserve FOMC monetary policy expectations being particularly active The Fed's Rate Cut Space Repriced Before Year-End! Is This Year's Rate Cut Script the Same as Last Year?

A notable interest rate futures market transaction bets that the Fed is expected to cut rates multiple times this year, with the first cut set for September, and cuts anticipated in October and December as well. This operation, linked to short-term rate expectations, resonates with strategies betting on a steeper or more upward-sloping curve in the U.S. Treasury market.

The above chart shows the repricing of rate cut space before year-end—interest rate swap pricing indicates that by the December FOMC meeting, the Fed is expected to have cumulatively cut rates by 61 basis points and is trending upward.

Additionally, more aggressive traders are even betting that a script similar to that of 2024 is about to unfold—specifically, a 50 basis point cut in September, followed by consecutive cuts of 75 basis points in October and December.

“We must still remember the situation last summer— the Fed kept rates unchanged in July but then received weak labor market data and cut rates by 50 basis points in September 2024,” analysts at Citigroup wrote.

On Friday, there was a surge in buying of U.S. Treasuries—amid a sharp decline in the stock market and other risk assets, contrasting sharply with the significant rebound in global stock markets earlier in the week and in mid-April. At that time, global bond traders significantly reduced their exposure, ending July with losses.

Especially on Wednesday, Fed Chairman Jerome Powell conveyed a hawkish message, stating that the labor market “remains balanced,” calling for patience in the face of still robust economic data and inflation slightly above the Fed's target.

“Powell essentially ruled out a rate cut in September at that time—he gave you the green light to short the short end,” said Tony Farley, Managing Director of Interest Rate Sales and Trading at Mischler Financial Group. However, weak employment data “slapped Powell in the face,” forcing investors to cover their shorts.

Employment Data Disrupts Calm in Global Financial Markets, "Bad News is Just Bad News" Returns to Market Trading Framework

The July employment report released in early August provided support for the view that “a rate cut should have happened in July,” including dissent from Fed governors Waller and Bowman, as well as pressure from U.S. President Donald Trump. At the same time, Trump accused the head of the Bureau of Labor Statistics of politicizing the employment report and called for his dismissal, further shaking an already fragile market.

Kathy Bostjancic, Chief Economist at Nationwide, stated: “The cracks in the labor market have widened significantly, further intensifying the pressure for the Fed to cut rates and supporting the dissenting views of Fed governors that the FOMC should cut rates this week.” With the non-farm payrolls settled, traders must assess how much of Friday's rally is a result of the negative sentiment previously weighing on U.S. Treasuries being released. For the bulls, the challenge is whether the deterioration in employment signals a significant weakening of the U.S. economy, which could offset the inflationary risks associated with tariffs in the coming months.

The July non-farm payrolls are just one monthly data point: before the next Federal Reserve FOMC monetary policy meeting, the market will face two months of key economic indicators, including two inflation reports and the next non-farm employment figures.

The stock market crash and bond market surge caused by unexpectedly weak non-farm payrolls indicate that the "bad news = good news" theory is gradually collapsing, and the market trading logic is returning to "bad news is just bad news." This return to logic is undoubtedly a significant positive catalyst for U.S. Treasury bulls.

The "bad news is good news" theory has long been one of the catalysts driving the rise in U.S. stock valuations—meaning that a sluggish U.S. economy implies that the Federal Reserve will become increasingly aggressive in cutting interest rates, which in turn benefits U.S. stocks and other risk assets. However, with the weak non-farm payrolls severely impacting risk assets, this theory has recently been in a state of "collapse," and the sluggish U.S. Treasuries this year may see a strong rally.

"This report clearly raises the probability of a rate cut in September, but it's not a done deal, as the unemployment rate remains low and the higher effective tariff rates bring inflationary risks," said Priya Misra, a portfolio manager at JP Morgan Asset Management. She noted that the "tighter tug-of-war" between labor weakness and sticky inflation means that pricing the timing and pace of rate cuts will be a bumpy journey.

However, Misra from JP Morgan leans towards increasing overall bond allocation and "moderately reducing steepening positions in the portfolio when taking profits to cope with the stagflationary policy mix brought about by tariffs and low immigration."

"The painful trades in positions are now clearly visible and could create a domino effect. Asset management firms globally were the main buyers of U.S. Treasuries on Friday. Government data indicates that some institutions have recently reduced their long positions, and the current market conditions are likely to put them in a painful passive position," said Alessandra Andres, a rates market strategist from Bloomberg Strategists MLIV.

Looking ahead to this week, investors will face a large issuance of Treasuries for quarterly refinancing, which could further support curve steepening. The government will issue a total of $125 billion in securities, including $6.7 billion in 10-year and 30-year bonds. The massive supply could push long-end yields higher, as the market has expressed concerns about the fiscal deficit and debt levels of the Trump administration following the passage of the "big and beautiful" bill.

John Canavan, an analyst at Oxford Economics, stated, "The preference for steepening could push the 10-year U.S. Treasury yield back above 4.30% in the short term, especially as the market awaits the upcoming Treasury refinancing auctions." The 10-year U.S. Treasury yield closed at around 4.22% on Friday.

James Acy from Marlborough Investment Management still holds a steepening position in U.S. Treasuries, but he believes this trend may take time to further unfold. In the context of intertwined trade and inflation uncertainties, more evidence of a slowdown in the U.S. economy and continued rate cuts by the Federal Reserve is needed. However, he expects that this data will eventually emerge, paving the way for the Federal Reserve's rate-cutting cycle "If we enter a true rate-cutting cycle again, the U.S. Treasury yield curve will always steepen in a bull market, and that is exactly our strategic outlook," said Axi