U.S. government bonds rose on Friday after Fed Chairman Jerome Powell said the central bank could cut rates as soon as next month. However, with important inflation and employment data yet to be released, the market may be volatile ahead of the Fed meeting on September 17.

Powell indicated the end of eight months of easing, stating that risks from the labor market could "be considered for adjusting our policy." Government bonds rose in price, and the spread between short and long-term limits widened the most in four years.

The market does not dare to confirm that a rate cut is certain. Futures contracts indicate an almost 80% chance of a 0.25 point cut in September. Yields, although lower, did not exceed this month's lows as traders await employment and inflation reports before deciding.

This suggests the Fed is weighing the weakening labor market against the risks that President Donald Trump's protectionist measures could push inflation up.

All eyes are on the inflation index and bond auctions

The Fed's preferred inflation index may show strong pressures, and the auction of two, five, and seven-year bonds will test demand.

"Powell reinforces market expectations for a cut in September," says Gregory Peters, deputy chief investment officer at PGIM Fixed Income.

"What's important is not whether a cut will happen in September or October. We don't know what the next six months will look like. It will still be a diverse data environment, keeping the bond market on edge."

Short-term yields led the move on Friday, according to Bloomberg. Two-year bonds fell 10 basis points to 3.7%, close to early August lows after weak employment reports. In futures contracts, traders estimate there will be two 0.25 point cuts by the end of the year, with a small chance of a third cut, as reported by Cryptopolitan.

Pricing "is the appropriate response," says John Briggs, head of U.S. interest rate strategy at Natixis North America, but "anything beyond two cuts before we get the employment data is too aggressive."

The move stimulates bets that the curve will steepen faster than the long curve as easing policy supports growth and pushes the gap between five and 30-year yields to the widest since 2021.

Investors prefer short-term bonds over long-term ones

Investors remain more comfortable in the short term, which could appreciate as the Fed begins to ease. Long-term bonds attract less demand as they face future inflation and increasing deficits.

This thinking also serves as a safeguard against pressure from the Fed. Trump has criticized Powell and threatened to fire Governor Lisa Cook over allegations of mortgage fraud. Cook stated that she would not bend under pressure to resign.

Such attacks on the independence of the central bank worry the market.

"The front part now has Chairman Powell's support, and yields there should remain stable," says Padhraic Garvey of ING, head of research in the Americas. "The back part does not favor this," he adds, saying that "this may reflect doubts that the Fed could be risking inflation here."

Another risk is that cutting while inflation remains high - and could rise - may limit the reduction of 10-year and long-term yields. The end of 2024 is a reminder: long-term yields rise even when the Fed cuts by one to one percent.

Market-based inflation expectations also rose slightly on Friday.

"If we have a Fed cutting in an environment where inflation is still far from their target, we think the market will show more signs of this inflation target rising and becoming unstable," says Meghan Swiber, interest rate strategist at Bank of America.

Positive surprises on growth or prices could trigger another sell-off ahead of the meeting.

"There is still a long way to go from now until September 17," says Michael Arone, who serves as chief investment strategist at State Street Global Advisors.

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