To trade the Fed’s pivot, Wall Street is turning to short-term debt
(Bloomberg) — The best way to play the Federal Reserve’s pivot toward monetary easing is to load up on debt with shorter maturities that still offers a yield above 4%.
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That’s the sentiment in the Treasury market as the Fed – with inflation falling – prepares to cut interest rates and support a soft landing. Meanwhile, much of the nearly $6 trillion parked in money market mutual funds has a new reason to move into Treasuries, as investors fear interest rates on cash-like investments will soon fall.
Add to this the strong conviction that the economy may avoid the recession that was once seen as inevitable, and investors’ lack of appetite for longer-dated securities as they expect the yield curve to steepen to its usual upward slope. The consensus on Wall Street is clear: Two-year Treasuries are the sweet spot on the yield curve, offering an attractive yield of about 4.4% that is higher than any other maturity.
“The Fed has given us their projections for 2024 and 2025 of where interest rates will go and then come down,” said Lindsay Rosner, a portfolio manager at Goldman Sachs Asset Management. Investors should target “a mix of two and five,” she said, because “outside the curve is not where we see much value.”
Long-term debt is expected to underperform, as traders want to be compensated for the additional risks they see involved in these securities. Among their concerns: the continued onslaught of issuances to finance the ever-high US government deficit, as well as the risks that inflation may reignite next year.
It’s easy to see why the two-year note is so attractive by looking at the yield curve. It has reversed this cycle for the first time in more than a year and a half, resulting in long-term interest rates trading below those on shorter-dated debt. Many investors are betting that it will return to normal sometime next year. At present, ten-year bonds yield about 50 basis points less than two-year debt. In July, the gap reached more than 100 basis points.
68% of respondents to the Instant Markets Live Pulse survey conducted by Bloomberg after the Fed meeting expected the curve to turn positive sometime in the second half of 2024 or later. While 8% said that this will happen in the first quarter and 24% in the second quarter.
Top investors, including DoubleLine Capital LP’s Jeffrey Gundlach, Bill Gross — the former bond king of Pacific Investment Management Co. — and billionaire investor Bill Ackman, predict the curve will flatten. Gundlach says US 10-year bond yields will fall toward the low 3% range next year, while Gross and Ackman believe a positive slope could emerge by the end of 2024.
Fed policymakers on Wednesday expected not to raise interest rates again and left the target range between 5.25% to 5.5%. Officials’ quarterly forecasts also showed cuts of 75 basis points next year, with the federal funds rate falling to 3.6% by the end of 2025. From there, it would fall to 2.9% the following year.
Brandywine Global Investment Management LLC is among the investors already gearing up. “Cash is great and you should have gotten out of the curve,” portfolio manager Jack McIntyre said. He prefers to “skip two years and buy five years and beyond,” because there is some risk about whether “the Fed will commit to a soft landing.”
The sudden shift in the bond market highlighted a feeling that 5% Treasury yields — as seen in October — were too good to pass up, widening the rally for many fixed income funds that had been anticipating some time ago. Another poor performance this year is not far off. The Bloomberg Treasury Index rose 3.5% this year through December 15, after an unprecedented loss of 12.5% last year and 2.3% in 2021.
However, investors with bearish positions lost out, a trend that was highlighted on Friday after New York Fed President John Williams said talk of a possible rate cut by March was “premature.” After the upward spike in yields, buyers quickly intervened and left interest rate cut expectations little changed. The swap shows a roughly 80% chance the Fed will cut interest rates as early as March. In total, the market expects an easing of 1.64 percentage points by the end of 2024.
In Europe, investors are also trying to figure out how to pivot even as central banks there fall short of market expectations. For the eurozone central bank, traders expect six quarter-point cuts in 2024, while in the UK, bets are on 115 basis points of easing next year, which translates to four quarter-point cuts with a fifth hanging in the balance. This means 40 basis points more than a week ago.
As long as upcoming data supports this narrative, overall bond market sentiment is likely to remain bullish, with any reserve increases in yield bought in.
However, there are potential risks along the way, said Michael De Passe, global head of interest rates trading at Citadel Securities LLC. “It certainly looks like all markets are anticipating a perfectly smooth landing at this point and any deviation from that narrative leaves the risk of repricing,” he said.
what do you want to watch
December 18: Federal Service Commercial Activity in New York; NAHB Housing Market Index
December 19: TIC flows. building permits; Housing begins
December 20: Applications for Master of Real Estate Business Administration; The current account balance; Existing Home Sales; Consumer Confidence/Expectations Conference
December 21: GDP; personal consumption; Unemployment claims rates; GDP Price Core Personal Consumption Expenditure Price; Business Outlook for the Federal Reserve Bank of Philadelphia; Kansas City Fed Manufacturing Leading Index
December 22: Personal Income/Spending; PCE shrinkage coefficient; bear goods; Bloomberg, December, American Economic Survey; U of Michigan Vibes; Federal Reserve Bank of Kansas City Services Activity
December 18: 13 and 26 week bills
December 19: Cash management invoices for 42 days
December 20: 17 weeks bills; Reopening of 20-year bonds
December 20: 4 and 8 week bills; Reopening tips for 5 years
–With assistance from Allen Oyamada.
(Updates to Treasury index return. An earlier version was issued to correct the direction of the Fed’s move derived from swap bets.)
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