(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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The US 10-year yield has climbed more than three-quarters of a percentage point since central bankers began cutting benchmark 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 secured a third consecutive rate cut, the 10-year Treasury yield rose to a seven-month high after policymakers led by Chairman Jerome Powell signaled they were ready to slow the pace of monetary easing significantly next year.
“Treasuries have been repriced to the idea of a longer-term higher and a more hawkish Fed,” said Sean Simko, head of global fixed-income portfolio management at SEI Investments Co. He sees the trend continuing, led by higher long-term yields.
Rising yields underline just how unique this economic and financial cycle has been. Despite high borrowing costs, a resilient economy has kept inflation stubbornly above the Fed's target, forcing traders to unwind bets on aggressive cuts and abandon hopes for a broad rally in bonds. After a year of sudden turmoil, traders are now looking at another year of disappointment, with Treasuries barely breaking even.
The good news is that a popular strategy that has worked well during past easing cycles has gained renewed momentum. The trade, known as a curve steeper, is an inducement that short-term Fed-sensitive Treasuries would outperform their longer-term counterparts—which they typically have recently.
'Pause Period'
Otherwise, the outlook is challenging. Not only do bond investors have to contend with a Fed that is likely to wait for some time, they also face potential upheaval from the new administration of President-elect Donald Trump, who has promised to reshape the economy through policies from trade to immigration. that many experts see as inflation.
“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 goes on, the more likely the markets will have to raise price equal to a rate cut. Policy uncertainty will lead to more volatile financial markets in 2025.”
What Bloomberg strategists say…
The final Federal Reserve meeting of the year is in the background and its results are likely to support curve steepers at the turn of the year. Although once the Donald Trump administration takes the helm in January, that dynamic has room to slow down amid the uncertainty surrounding the government's new policies.
—Alyce Andres Read more on MLIV
Bond traders were caught off guard last week after Fed policymakers expressed more caution about how quickly they can continue to reduce borrowing costs amid persistent inflation concerns. Fed officials made just two quarter-point cuts in 2025, after lowering interest rates by a full percentage point from a two-decade high. Fifteen of 19 Fed officials see risks alongside inflation, compared to just three in September.
Traders quickly recalibrated their rate expectations. Interest rate swaps showed traders haven't fully priced in another cut until June. They are betting a total decline of about 0.37 percentage points next year, less than the median projection of half a point on the Fed in the so-called dot-plot. In the options market, however, trade flow has veered towards a more dovish policy path.
Bloomberg's benchmark for Treasuries fell for a second week, all without erasing this year's gains, with long-dated bonds leading the selloff. Since the Fed began cutting rates in September, US government debt has fallen by 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 strategists at JPMorgan Chase & Co., led by Jay Barry, have recommended that clients buy two-year notes, they said they do not “feel compelled” to buy longer-maturity debt, citing a lack of key economic data in the coming weeks. and thinner trading to the end of the year, as well as fresh supply. The Treasury is expected to auction $183 billion of securities in the coming days.
The current environment has created the perfect conditions for the steeper strategy. US 10-year yields traded a quarter of a point higher than those on two-year Treasuries at one point last week, marking the biggest gap since 2022. The gap narrowed somewhat on Friday after data showed the Fed last month's preferred inflation measure is the slowest. speed since May. But the trade is still a winner.
The logic behind this strategy is easy to understand. Investors are starting to see value in the so-called short end because, at 4.3%, the yield on two-year notes is almost equal to the cash equivalent of three-month Treasury bills. But two-year notes have the added benefit of potential price appreciation if the Fed cuts rates more than expected. They also offer value from a cross-asset perspective, given the extended valuations of US stocks.
“The market sees bonds as cheap, certainly compared to stocks, and sees them as insurance against an economic slowdown,” said Michael de Pass, head of global rates trading at Citadel Securities. “The question is, how much do you have to pay for that insurance? If you look at the very front end now, you don't have to pay a ton.”
In contrast, longer-dated bonds are struggling to attract buyers amid sticky 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 to consider the administration and the spending of president-elect Trump – that certainly can and will push those longer-term yields higher,” said Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, which oversees $1.3 trillion.
Hunstad said he favors inflation-linked bonds as “pretty cheap insurance” against rising consumer prices.
What to watch
Economic data:
20 December: University of Michigan consumer confidence survey (final); Kansas City Fed services activity
23 December: Chicago Fed National Activity Index; Consumer Confidence Conference Board
December 24: Building Permits; Philadelphia Fed non-manufacturing activity; Durable goods; New home sales; Richmond Fed manufacturing index and business conditions
December 26: Initial jobless claims;
December 27: Advance goods trade balance; wholesale, retail listings
Auction calendar:
December 23: 13-, 26-, 52-week bills; 42 day cash management bills; two year notes
December 24: Two-year FRN reopens; five year notes
December 26: 4-, 8-, 17-week bills; seven year notes
