(Bloomberg) — Bond traders have rarely suffered much from a Fed easing cycle. Now they fear 2025 threatens more of the same.
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US 10-year bond yields have risen more than three-quarters of a percentage point since central bankers began cutting benchmark interest rates in September. It’s a counterintuitive and loss-making response, marking the biggest jump in the first three months of an interest rate-cutting cycle since 1989.
Last week, even as the Federal Reserve cut interest rates for the third straight time, 10-year Treasury yields rose to a seven-month high after policymakers led by Chairman Jerome Powell signaled they were ready to significantly slow the pace of monetary easing in… Next year.
“Treasuries have been repricing on the idea of a longer rally and a more hawkish Fed,” said Sean Simcoe, global head of fixed income portfolio management at SEI Investments Co. He sees the trend continuing, led by rising long-term yields.
The rise in returns confirms the distinctiveness of this economic and monetary cycle. Despite rising borrowing costs, the resilient economy has kept inflation above the Fed’s target, forcing traders to back off bets on aggressive cuts and abandon hopes of a broad rise in bonds. After a year of sharp ups and downs, traders are now awaiting another year of disappointment, with Treasuries as a whole barely breaking even.
The good news is that a popular strategy that has worked so well over past easing cycles has gained renewed momentum. The trade, known as steepening the curve, is a bet that the Fed’s sensitive short-term Treasuries will outperform their longer-term counterparts — which is generally what has happened recently.
“pause phase”
Otherwise, the forecast is difficult. Not only do bond investors have to contend with a Fed that is likely to stay in place for some time, they also face potential disruptions from the incoming administration of President-elect Donald Trump, who has vowed to reshape the economy through policies ranging from trade to immigration. Which many experts see as inflationary.
“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 this lasts, the more likely it is that markets will have to equally price a rate hike versus a rate cut. Policy uncertainty will increase volatility in financial markets in 2025.”
What Bloomberg strategists say…
The Fed’s final meeting of the year is in the rear view and its results are likely to support curve-steepening factors at the turn of the year. Although once Donald Trump’s administration took office in January, this dynamic had room to stall amid uncertainties surrounding the new government’s policies.
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Bond traders were surprised last week after Federal Reserve policymakers signaled greater caution about how quickly they could continue to cut borrowing costs amid persistent inflation concerns. Fed officials expected just two quarter-point cuts in 2025, after cutting interest rates by a full percentage point from their highest level in two decades. Fifteen out of 19 Fed officials see upside risks to inflation, compared to just three in September.
Traders quickly reset their interest rate expectations. Interest rate swaps showed that traders had not fully priced in another cut until June. They are betting on an overall cut of about 0.37 percentage points next year, half a percentage point below the Fed’s average forecast. But in the options market, trade flows have veered towards a more pessimistic political path.
The Bloomberg Treasury Bond Index fell for a second week, erasing this year’s gains, as longer-term bonds led the selling. Since the Fed started cutting interest rates in September, US government debt has fallen by 3.6%. By comparison, bonds have generated positive returns in the first three months of each of the past six easing cycles.
The recent declines in long-term bonds haven’t attracted many bargain hunters. While strategists at JPMorgan Chase & Co., led by Jay Barry, recommended clients buy two-year bonds, they said they “don’t feel compelled” to buy longer-maturity debt, citing the lack of major economic data in the coming weeks. And less trading at the end of the year, in addition to the new supply. The Treasury Department is scheduled to auction $183 billion worth of securities in the coming days.
The current environment has created the ideal conditions for a regression strategy. U.S. 10-year Treasury yields traded a quarter of a percentage point above two-year Treasury yields at one point last week, marking the widest gap since 2022. The spread narrowed somewhat on Friday after data showed the bank’s preferred measure of inflation… The Federal Reserve advanced last month at its slowest pace since May. But the trade is still a winner.
It is easy to understand the logic behind this strategy. Investors begin to see value at the so-called short end, because yields on two-year Treasuries, at 4.3%, are roughly on par with three-month Treasuries, their cash equivalent. But two-year bonds have the added advantage of potentially rising rates if the Fed cuts interest rates more than expected. They also provide value from a multi-asset perspective, given the stretched valuations of US stocks.
“The market views bonds as cheap, certainly compared to stocks, and sees them as insurance against an economic slowdown,” said Michael de Passe, global head of interest rates trading at Citadel Securities. “The question is, how much do you have to pay for this insurance? If you look at the front end now, you won’t have to pay as much.”
In contrast, longer-term bonds are struggling to attract buyers amid steady inflation and a still strong economy. Some investors are also concerned about Trump’s policy program and its ability to not only fuel growth and inflation, but also exacerbate already huge budget deficits.
“When you start taking into account President-elect Trump’s administration and the spending, it certainly could push those long-term returns higher, and it will,” said Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, which oversees $1.3 trillion. “To that.”
Hunstad said he favors inflation-linked bonds as “very cheap insurance” against rising consumer prices.
What to watch
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Economic data:
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December 20: University of Michigan Consumer Confidence Survey (final); Federal Services Activity in Kansas City
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December 23: Chicago Fed National Activity Index; Consumer Confidence Council Conference
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December 24: Building permits; Federal Reserve Bank of Philadelphia non-manufacturing activity; durable goods; New Home Sales; Richmond Fed Index of Manufacturing and Business Conditions
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December 26: Initial unemployment claims.
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December 27: Advanced Goods Trade Balance; Wholesale and retail stocks
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Auction Calendar:
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December 23: 13, 26 and 52 week bills; 42-day cash management invoices; Two-year diary
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December 24: FRN reopens for two years; Five-year notes
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December 26: 4, 8 and 17 week bills; Diary of seven years
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– With the assistance of Edward Bolingbroke.
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