Investors who have been hedging against a deeper selloff in US Treasuries are preparing for increased volatility as the release of the highly anticipated US employment report on Friday and the upcoming Federal Reserve policy decision next week offer crucial insights into the direction of the bond market.

Bracing for Turbulence: Investors Gear Up for a Pivotal Week in the Bond Market

Anticipating the Impact of Economic Data and the Fed's Next Move

US bonds remained relatively unchanged in early Asian trading on Friday, following a dismal October performance that saw the worst monthly results in two years. With the looming election and the Fed meeting just days away, a measure of daily yield swings has reached its highest point in a year as traders position themselves for further losses. This could potentially send 10-year yields as high as 4.5% over the next three weeks, compared to the current level of around 4.3%.This positioning makes the evidence of a robust US labor market in the government data released on Friday a crucial factor that the market cannot ignore, according to Jack McIntyre, portfolio manager at Brandywine Global Investment Management. While weak data could be attributed to the impact of strikes and storms, a strong jobs report would remove pressure on policymakers as they consider lowering interest rates.

The Fed's Balancing Act: Navigating Expectations and Policy Decisions

McIntyre believes the Federal Reserve is unlikely to surprise the markets too much, and he expects a quarter-point rate cut at next week's meeting, in line with the consensus among most economists surveyed by Bloomberg. However, he anticipates the Fed will send a hawkish message and signal that they are done cutting rates for a while.The selloff in Treasuries over the past month, with yields rising by roughly 60 basis points, has been sparked in part by an unexpectedly strong reading of September's job data. Since then, volatility has increased in anticipation of the upcoming presidential debate and the uncertainty surrounding the Fed's policy path.

Volatility Spikes as Traders Brace for Turbulence

The ICE BofA Move Index, a closely watched gauge of US bond-market volatility, closed at its highest level this year this week, indicating that traders are willing to pay a premium to protect against increased turbulence. A notable flow on Thursday included a long volatility play for a premium of $10 million via options linked to the Secured Overnight Financing Rate.Traders are currently pricing in about a 90% chance that the Fed will cut rates by a quarter point next week, which is smaller than the half-point reduction in September. Swap rates anticipate a total of about 117 basis points of easing over the next 12 months, about 67 basis points less than at the beginning of October.

Shifting Positions and Expectations in the Bond Market

The unwinding of positions has been reflected in the cash market, where the latest survey from JPMorgan Chase & Co. shows clients reducing both long and short positions, with neutrals on the rise.In the options market, traders have been positioning for a further selloff. Thursday's flows included a $6.5 million premium bet on a 4.4% 10-year yield by November 22, while the most-populated option put strike targets a rise to 4.5%.While the October jobs report is unlikely to alter expectations for the November Fed decision, the data could still "move market expectations for the path of rate cuts during future meetings," said Greg Wilensky, head of US fixed income at Janus Henderson Investors. Traders will pay close attention to the unemployment rate, which economists forecast will remain steady at 4.1%. Strong data has the power to bolster bond-market expectations for a potential pause in interest-rate cuts early next year.

The Fed's Balancing Act: Lowering Rates and Signaling Future Policy

While the Fed will likely lower rates next week, "shifting to a quarterly pace of 25 basis point cuts by skipping January remains the path of least resistance and is consistent with our expectations – as well as a relatively consensus take at the moment," according to Ian Lyngen, head of US rates strategy at BMO Capital Markets.As investors navigate the turbulent bond market, they must carefully weigh the impact of economic data, the Fed's policy decisions, and the broader market sentiment. With volatility on the rise and the potential for significant shifts in yields, investors must remain vigilant and prepared for the challenges and opportunities that lie ahead.