(Bloomberg) — Bond traders have rarely suffered so much from a Federal Reserve dovish cycle. Now they fear that 2025 threatens more of the same.
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US 10-year yields have risen more than three-quarters of a percentage point since central bankers started cutting interest rates in September. It’s a counterintuitive, loss-making response that marks the biggest jump in the first three months of a rate-cutting cycle since 1989.
Last week, even as the Fed cut rates for the third time in a row, 10-year Treasury yields rose to their highest level in seven months, after policymakers led by Chairman Jerome Powell signaled their willingness to slow the pace of monetary easing to slow down significantly next year.
“Government bond prices have adjusted to the idea of higher longer and a more aggressive Fed,” said Sean Simko, global head of fixed income portfolio management at SEI Investments Co. He sees the trend continuing, led by higher long-term interest rates.
Rising interest rates underline how unique this economic and monetary cycle has been. Despite high borrowing costs, a resilient economy has kept inflation stubbornly above the Fed’s target, forcing investors to abandon bets on aggressive spending cuts and abandon hopes for a broad rally in bonds. After a year of sharp ups and downs, traders are now heading into another year of disappointment, with government bonds as a whole barely breaking even.
The good news is that a popular strategy that has worked well during recent easing cycles has regained momentum. This trade, known as a curve steeper, is a bet that Fed-sensitive short-term bonds would outperform their longer-term counterparts – which they tend to do lately.
‘Pause phase’
Otherwise, the outlook is challenging. Not only are bond investors dealing with a Fed that is likely to remain in place for some time, they are also facing potential turbulence from the incoming administration of President-elect Donald Trump, who has promised to overhaul the economy through a policy from trade to immigration. which many experts consider 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 continues, the more likely it is that markets will have to price a rate hike to the same extent as a rate cut. Policy uncertainty will create more volatile financial markets in 2025.”
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The Federal Reserve’s final meeting of the year is in the tail end and its results are likely to support curve steepening through the turn of the year. But once Donald Trump’s administration takes over in January, that momentum could come to a halt amid the uncertainties surrounding the administration’s new policies.
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Bond traders were caught off guard last week after Fed policymakers signaled greater caution about how quickly they can continue to cut borrowing costs amid lingering inflation concerns. Fed officials have cut just two quarter points in 2025, after cutting rates by a full percentage point from a two-decade high. Fifteen of 19 Fed officials see upside risks to inflation, up from just three in September.
Traders quickly recalibrated their interest rate expectations. Interest rate swaps show that traders only fully priced in a new cut in June. They expect a total cut of about 0.37 percentage points next year, less than the half-point average projection on the Fed’s so-called dot plot. However, in the options market, trade flows have shifted towards a smoother policy path.
Bloomberg’s benchmark for government bonds fell for a second week, nearly erasing this year’s gains, with long-term bonds leading the sell-off. Since the Fed started cutting rates in September, US government debt has fallen by 3.6%. By comparison, bonds delivered positive returns in the first three months of each of the past six easing cycles.
The recent declines in long-term bonds have not attracted many bargain hunters. While strategists at JPMorgan Chase & Co., led by Jay Barry, recommended that clients buy two-year notes, they said they don’t feel “compelled” to buy longer-term debt, citing the lack of significant economic data in the coming weeks. and thinner trade until the end of the year, as well as fresh supply. The Treasury Department will auction $183 billion worth of securities in the coming days.
The current climate has created the perfect conditions for the steepening strategy. U.S. 10-year yields traded a quarter point higher than two-year Treasury yields at one point last week, marking the biggest gap since 2022. The gap narrowed slightly on Friday after data showed the Fed’s preferred inflation measure rose at its slowest last month. pace since May. But the trade is still a winner.
It is easy to understand the logic behind this strategy. Investors are starting to see value in the so-called short segment, because the yield on two-year government bonds, at 4.3%, is almost equal to that on three-month government bonds, a cash equivalent. But two-year bonds have the added benefit of a potential price increase if the Fed cuts rates further than expected. They also offer value from a cross-asset perspective, given the high valuations of US equities.
“The market sees bonds as cheap, especially relative to equities, and sees them as insurance against an economic slowdown,” said Michael de Pass, global head of interest rate trading at Citadel Securities. “The question is: how much do you have to pay for that insurance? If you look at the front now, you don’t have to pay a ton.”
In contrast, longer-term bonds are struggling to entice buyers amid persistent inflation and a still-robust economy. Some investors are also wary of Trump’s policy platform and its potential to not only fuel growth and inflation, but also worsen an already large budget deficit.
“When you start factoring in President-elect Trump’s administration and spending, it certainly can and will push longer-term returns higher,” said Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, which oversees $1.3 trillion.
Hunstad said he prefers inflation-linked bonds as “fairly 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); Kansas City Fed Services Activity
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December 23: Chicago Fed National Activity Index; Consumer Confidence Conference Council
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December 24: building permits; Non-productive activities of the Philadelphia Fed; Durable goods; Sales of new houses; Richmond Fed Manufacturing Index and Business Conditions
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December 26: First unemployment claims;
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December 27: Progress on the merchandise trade balance; wholesale, retail supplies
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Auction calendar:
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December 23: 13, 26 and 52 week bills; 42-day cash management accounts; biennial notes
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December 24: Two-year reopening of FRN; five-year notes
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December 26: 4, 8, 17 week bills; banknotes of seven years
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–With assistance from Edward Bolingbroke.
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