Bond Traders Face Uncertain Future as Fed Easing Cycle Falters
The Federal Reserve’s latest rate-cutting cycle has left bond traders reeling, with US 10-year yields surging to a seven-month high despite policymakers’ efforts to ease borrowing costs. This counterintuitive response marks the biggest jump in the first three months of a rate-cutting cycle since 1989.
A Resilient Economy Keeps Inflation High
Despite elevated borrowing costs, the economy remains robust, keeping inflation stubbornly above the Fed’s target. This has forced traders to unwind bets for aggressive cuts and abandon hopes for a broad-based rally in bonds. As a result, Treasuries as a whole have barely broken even over the past year.
Curve Steepeners Gain Momentum
However, a popular strategy known as a curve steepener has gained renewed momentum. This trade involves wagering that Fed-sensitive short-term Treasuries will outperform their longer-term counterparts, which has generally been the case of late.
The “Pause Phase” of Monetary Policy
The outlook for bond investors remains challenging, with the Fed likely to stay put for some time and potential turbulence from the incoming administration of President-elect Donald Trump. “The Fed has entered a new phase of monetary policy — the pause phase,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The longer it persists, the more likely the markets will have to equally price a rate hike versus a rate cut.”
Uncertainty Ahead
The recent declines in long-term bonds haven’t attracted many bargain hunters, with strategists citing the lack of key economic data in the weeks ahead and thinner trading into year-end. The Treasury is slated to auction $183 billion of securities in the days ahead, adding to the uncertainty.
Steepener Strategy Gains Traction
The current environment has created the perfect conditions for the steepener strategy, with US 10-year yields trading a quarter-point above those on two-year Treasuries at one point last week. This differential narrowed somewhat after data showed the Fed’s preferred measure of inflation advanced last month at the slowest pace since May.
Investors Seek Value in Short-Term Bonds
Investors are starting to see value in short-term bonds, with yields on two-year notes almost on par with three-month Treasury bills, a cash equivalent. Two-year notes also offer value from a cross-asset standpoint, given US stocks’ stretched valuations.
Long-Term Bonds Struggle to Entice Buyers
In contrast, longer-term bonds are struggling to entice buyers amid sticky inflation and a still robust economy. Some investors are also wary of Trump’s policy platform and its potential to fuel growth and inflation, as well as worsen an already large budget deficit.
What to Watch in the Coming Weeks
Economic data releases, including the University of Michigan consumer confidence survey and the Chicago Fed National Activity Index, will be closely watched in the coming weeks. The auction calendar is also packed, with the Treasury set to auction $183 billion of securities.
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