(Bloomberg) — In the world of bond trading, few scenarios have been as painful as navigating through a Federal Reserve easing cycle. As we look toward 2025, traders are bracing for what may be a similarly tumultuous ride.
Since the central bank began reducing benchmark interest rates back in September, US 10-year yields have surged over three-quarters of a percentage point. This unexpected climb marks the largest increase during the initial three months of a rate-cutting cycle since 1989, catching many off guard.
Despite yet another rate cut announced by the Fed last week, 10-year Treasury yields still peaked to a seven-month high. That’s largely because policymakers, led by Chair Jerome Powell, hinted at a more gradual approach to monetary easing in the upcoming year.
“There’s been a shift in the market perception to expect higher rates for a longer duration, indicating a more hawkish stance from the Fed,” explained Sean Simko, SEI Investments Co.’s global head of fixed-income portfolio management. He anticipates this trend of rising long-term yields to persist.
This economic cycle has been anything but typical. Even with higher borrowing costs, a robust economy has led to persistently high inflation, compelling traders to retract their bets on aggressive rate cuts and shelving hopes for a bond rally. It’s been a roller coaster year in the bond markets, and the outlook for 2025 isn’t exactly rosy, with Treasuries struggling to hold their ground.
Yet, there is a silver lining. A familiar strategy that’s been successful in past easing cycles is gaining traction again. Known as the "curve steepener," this approach involves betting that short-term Treasuries, sensitive to Fed policy, will outperform their longer-term counterparts—a trend we’ve been witnessing lately.
Looking ahead, bond investors are facing challenging terrain. The Federal Reserve is likely to maintain its cautious stance for a while, compounded by potential volatility from President-elect Donald Trump’s incoming administration. His proposed economic reforms, spanning trade to immigration, are likely to stoke inflationary pressures.
Jack McIntyre, a portfolio manager with Brandywine Global Investment Management, describes the central bank’s current stance as a "pause phase." "The more prolonged this phase is, the more markets might have to equally weigh the prospects of both rate hikes and cuts," McIntyre noted, warning of the potential market volatility in 2025.
Looking back at the year’s final Fed meeting, its decisions could bolster curve steepeners as we transition into the new year. However, as Trump’s team begins their tenure in January, that momentum could face hurdles amidst uncertain policy directions.
Last week’s developments left traders scrambling. With Fed officials outlining a more cautious approach to rate cuts—eyeing just two quarter-point reductions in 2025 after a full percentage point drop from two-decade highs—many traders have had to swiftly adjust their expectations.
Market instruments reflecting rate projections, such as interest-rate swaps, haven’t fully accounted for another cut until June. They’re currently predicting roughly a 0.37 percentage point reduction in the coming year, falling short of the Fed’s forecasted half-point cut. Meanwhile, options markets indicate a tilt towards a more dovish outcome.
The Bloomberg benchmark for Treasuries experienced its second consecutive weekly drop, almost negating this year’s gains, with long-term bonds spearheading the downturn. Since September’s rate reductions began, US government debt has retreated by 3.6%. This contrasts with positive returns reported in the first quarter of prior easing cycles.
Surprisingly, this decline hasn’t sparked much interest in bargain hunting for long-term bonds. Strategists at JPMorgan Chase & Co., led by Jay Barry, suggest purchasing two-year notes. However, they remain hesitant about longer maturities due to scant economic data, thinner trading towards year-end, and the introduction of new securities, with the Treasury arranging to auction $183 billion in securities in the coming days.
The scene is set for the steepener strategy to thrive. At one point last week, US 10-year yields were a quarter-point above those on two-year Treasuries, the largest gap since 2022. Although data on Friday showed inflation slowing, narrowing the difference, the trade continues to be successful.
The appeal of this strategy is clear. As markets see value in short-term investments like two-year notes, especially with their yields rivaling those of three-month Treasury bills, investors appreciate their potential price growth should the Fed trim rates further. Additionally, from an asset allocation perspective, these notes are deemed favorable given stretched valuations in US stocks.
“Investors perceive bonds as undervalued, especially compared to equities, and consider them insurance against an economic downturn,” stated Michael de Pass, Citadel Securities’ global head of rates trading. “The key question revolves around the cost of that insurance, and the short end currently offers an attractive price.”
Longer-term bonds, however, are struggling to find their audience amid persistent inflation and a resilient economy. Additionally, concerns over Trump’s policy direction—which could spur growth and inflation while exacerbating an already growing budget deficit—add to the hesitation.
Michael Hunstad, deputy Chief Investment Officer at Northern Trust Asset Management, which manages $1.3 trillion in assets, expressed his favor for inflation-linked bonds as a "cost-effective insurance" against rising consumer prices.
Here’s what to keep an eye on:
Economic data coming up:
- Dec. 20: Final University of Michigan consumer confidence survey; Kansas City Fed services activity
- Dec. 23: Chicago Fed National Activity Index; Conference Board Consumer Confidence
- Dec. 24: Building Permits; Philadelphia Fed non-manufacturing activity; Durable goods; New home sales; Richmond Fed manufacturing index and business conditions
- Dec. 26: Initial jobless claims
- Dec. 27: Advance goods trade balance; wholesale, retail inventories
Auction schedule:
- Dec. 23: 13-, 26-, and 52-week bills; 42-day cash management bills; two-year notes
- Dec. 24: Reopening of two-year FRN; five-year notes
- Dec. 26: 4-, 8-, and 17-week bills; seven-year notes
With insight from Edward Bolingbroke.
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