(Bloomberg) — Bond traders have rarely suffered so much from a Federal Reserve easing cycle. Now they fear that 2025 threatens more of the same.
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U.S. 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, loss-inducing response that marks the biggest jump in the first three months of a rate cut cycle since 1989.
Last week, even as the Federal Reserve made a third straight rate cut, 10-year Treasury yields rose to a seven-month high after policymakers, led by Chairman Jerome Powell, signaled they were prepared to considerably slow the pace of monetary easing next year.
“Treasury bonds have been repriced based on the notion of a longer hike and a more hawkish 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 returns.
Rising yields underscore how unique this economic and monetary cycle has been. Despite high borrowing costs, a resilient economy has kept inflation stubbornly above the Federal Reserve’s target, forcing traders to unwind bets on aggressive cuts and abandon hopes of a broad-based bond rally. After a year of sharp ups and downs, traders now face another year of disappointment, with Treasuries as a whole barely breaking even.
The good news is that a popular strategy that has worked well during previous easing cycles has gained renewed momentum. The trade, known as curve steepening, is a bet that short-term, Federal Reserve-sensitive Treasuries would outperform their long-term counterparts, something they have generally done lately.
‘Pause phase’
Otherwise, the outlook is challenging. Bond investors not only have to contend with a Federal Reserve that is likely to remain stable for some time, but they also face potential turbulence from the incoming administration of President-elect Donald Trump, who has promised to reshape the economy through policies ranging from trade to immigration. which many experts consider inflationary.
“The Federal Reserve has entered a new phase of monetary policy: the pause phase,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The longer this persists, the more likely it is that markets will have to price a rate hike or a rate cut equally. “Political uncertainty will generate more volatile financial markets in 2025.”
What Bloomberg strategists say…
The last Federal Reserve meeting of the year is behind us and its results are likely to support steeper curves towards the turn of the year. Although once Donald Trump’s administration takes over in January, that dynamic is likely to stall amid the uncertainties surrounding the administration’s new policies.
—Alyce Andrés Read more on MLIV
Bond traders were caught off guard last week after Fed officials signaled greater caution about how quickly they can continue to reduce borrowing costs amid persistent inflation concerns. Federal Reserve officials forecast just two quarter-point cuts in 2025, after cutting interest rates by a full percentage point from a two-decade high. Fifteen of 19 Federal Reserve officials see upside risks to inflation, compared with just three in September.
Traders quickly recalibrated their rate expectations. Interest rate swaps showed traders have not fully priced in another cut until June. They’re betting on a total reduction of about 0.37 percentage points next year, less than the half-point median projection on the Fed’s so-called dot plot. However, in the options market, trade flows have shifted towards a more dovish policy.
Bloomberg’s benchmark Treasury index fell for a second week, virtually erasing this year’s gain, with long-term bonds leading the selloff. Since the Federal Reserve began cutting rates in September, US public debt has decreased 3.6%. By comparison, bonds had positive returns in the first three months of each of the last six easing cycles.
The recent declines in long-term bonds have not attracted many bargain hunters. While JPMorgan Chase & Co. strategists led by Jay Barry recommended clients buy two-year notes, they said they don’t “feel compelled” to buy longer-maturity debt, citing a lack of key economic data in the next few weeks. and smaller trade towards the end of the year, as well as a new offer. The Treasury is scheduled to auction $183 billion in securities in the coming days.
The current environment has created the perfect conditions for the deepening strategy. U.S. 10-year bond yields traded a quarter of a point above those on two-year Treasuries at one point last week, marking the widest gap since 2022. The spread narrowed a bit on Friday after after data showed the Federal Reserve’s preferred measure of inflation advanced at the slowest pace last month. rhythm since May. But trade is still a winner.
It’s easy to understand the logic behind this strategy. Investors are beginning to see value in the so-called short end because, at 4.3%, yields on two-year bonds are almost on par with three-month Treasuries, an equivalent of cash. But two-year bonds have the added advantage of potential price appreciation if the Federal Reserve cuts rates more than expected. They also offer value from an all-asset perspective, given the inflated valuations of US stocks.
“The market views bonds as cheap, certainly relative to stocks, and views them as insurance against an economic slowdown,” said Michael de Pass, global head of rates trading at Citadel Securities. “The question is how much do you have to pay for that insurance? “If you look from the beginning now, you won’t have to pay a ton.”
In contrast, longer-term bonds are struggling to attract buyers amid persistent inflation and a still robust economy. Some investors are also wary of Trump’s policy platform and its potential not only to boost growth and inflation but also to worsen an already large budget deficit.
“When you start factoring in President-elect Trump’s administration and spending, that certainly can and will increase those returns over the long term,” said Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, which oversees $1.3 trillion. dollars.
Hunstad said he favors inflation-linked bonds as “pretty cheap insurance” against rising consumer prices.
What to watch
Economic data:
December 20: University of Michigan Consumer Confidence Survey (final); Kansas City Fed Services Activity
December 23: Chicago Federal Reserve National Activity Index; Conference Board Consumer Confidence
December 24: Construction permits; Philadelphia Federal Reserve Non-Manufacturing Activity; Durable goods; New home sales; Richmond Fed Manufacturing Index and Business Conditions
December 26: Initial unemployment claims;
December 27: Advance in the trade balance of goods; wholesale and retail inventories
Auction calendar:
December 23: 13, 26 and 52 week bills; 42-day cash management invoices; two year notes
December 24: reopening of the two-year FRN; five year notes
December 26: 4, 8 and 17 week bills; seven year grades
