Markets Brace for Potential Government Shutdown Amid Fed Rate Cut Uncertainty

Financial markets are experiencing heightened uncertainty as a potential federal government shutdown looms in the United States. This comes at a time when Federal Reserve officials are expressing differing views on monetary policy, coupled with stronger-than-expected economic data, leading traders to reduce bets on further easing by the central bank.
Challenges Facing the Markets:
A potential government shutdown, possibly starting on October 1st, presents a significant dilemma for markets. It could delay the release of important economic data, most notably the non-farm payroll report due on Friday, which is one of the most closely watched economic indicators. It's worth noting that non-farm payroll and CPI reports were delayed by about two weeks after the full U.S. government shutdown in 2013.
Negotiations to Avert a Shutdown:
The top four U.S. congressional leaders are scheduled to meet with President Trump at the White House to discuss a short-term spending bill to avert a government shutdown. However, disagreements remain, particularly regarding medical subsidies. Democrats are demanding an extension of subsidies and a reversal of health budget cuts, while Republicans insist on resolving the shutdown crisis first before beginning negotiations. If no agreement is reached, federal funds will run out by midnight on Tuesday, local time.
Impact of Employment Data on Fed Decisions:
A weakening labor market prompted the Fed to cut interest rates for the first time this year. Traders believe there is an approximately 80% chance of a rate cut at the Federal Open Market Committee (FOMC) meeting scheduled for October 28-29. However, they may need more weak data to confirm a cooling labor market, reinforce expectations that the Fed will engage in further monetary easing, and keep U.S. government bonds on track for their best annual return since 2020.
Analyzing Investor Sentiment:
James Athey, a portfolio manager at Marlborough Investment Management Ltd., points out, "The jobs report is what markets need to start a rally from now on. It's the most important part of the 'weak economy, dovish Fed' story. But even if we do see the data, the threshold is quite high for a report weak enough to push U.S. Treasury yields lower from now on." He added that he is underweighting U.S. government bonds.
Treasury Yield Volatility:
The 10-year U.S. Treasury yield rose to around 4.2% last week, after falling to a five-month low of just under 4% on September 17. At that time, the Fed resumed monetary easing with a 25-basis-point cut, despite dissent from newly minted policymaker Neel Kashkari, who called for a 50-basis-point cut. Part of the rebound in Treasury yields is attributed to data showing a decrease in unemployment claims and strong growth in the U.S. economy in the second quarter.
Market Expectations for Rate Cuts:
These reports prompted traders to slightly reduce their expectations for monetary easing, but they still strongly favor a 25-basis-point rate cut next month and possibly in December. The market has priced in approximately one percentage point of easing in the next 12 months.
Impact of Weak Government Employment Data:
Weak government employment data in recent months has prompted the Fed to take a turn, even as inflation was above its 2% target. This move helped boost bonds, putting U.S. Treasuries on track for their best performance since 2020.
Expectations for the Upcoming Jobs Report:
Markets expect government data due on October 3 to show that the U.S. added 50,000 non-farm jobs in September, a rebound from an average of less than 30,000 in the previous three months. Last week, Fed Chair Jerome Powell said that the recent pace of job creation "appears to be running below the 'break-even' level needed to keep the unemployment rate stable."
Conflicting Risks Facing the Fed:
He reiterated that Fed policymakers are facing conflicting risks of a slowing labor market and rising inflation.
Divergent Views Among Fed Officials:
Officials have shown division in views on the path of monetary policy. Chicago Fed President Austan Goolsbee last week expressed concern about tariff-driven inflation and opposed any calls for multiple rate cuts "early." Meanwhile, Governor Michelle Bowman said inflation is close enough to the Fed's target that there is reason for further cuts because the labor market is weakening.
Conflicting Market Positions:
Market positions also show a similar divide. In the U.S. Treasury options market, there have been buyers betting on the 10-year U.S. Treasury yield falling to 4% or lower by the end of November. Meanwhile, a JPMorgan survey of its clients revealed a surge in short positions on U.S. Treasuries.
Vanguard's Perspective:
Sara Devereux, global head of fixed income at Vanguard, said, "We believe the current level of the 10-year U.S. Treasury yield is largely fair, and there is a balance between downside risks from labor market weakness and upside risks from improving growth prospects."
She added that the company's active fund managers tend to buy bonds when yields rise to the higher end of the recent range and favor bonds with maturities between 5 and 10 years.
Importance of ADP Data:
The risk of a government shutdown also increases the importance of unaffected data, including the ADP private employment report on October 1. While ADP is not always a reliable leading indicator of official data, recent downward revisions to government data have confirmed the weakness seen in the private report. Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, says:
"ADP will carry tremendous weight. A strong jobs number would open a door to many questions about the path of rates and the timing of rate cuts next year."
Conclusion:
In summary, financial markets face uncertainty due to the potential federal government shutdown and mixed economic data. Investors will closely monitor political negotiations and upcoming employment reports to assess the future path of interest rates and monetary policy in general. Investors should exercise caution and conduct thorough research before making any investment decisions based on these developments.