Market Analysis

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Bond investors are anticipating that the Federal Reserve will maintain interest rates steady this week while hinting that rate cuts are on the horizon. This expectation has led them to speculate that the U.S. Treasury yield curve will shift from its current inversion and revert to a normal positive slope.

Investors are adopting a "steepener" strategy, which involves taking bullish positions on short-term Treasuries and reducing exposure to long-term bonds. This approach benefits from a steeper yield curve, where long-term yields are higher than short-term yields, compensating investors for the increased risk of longer durations.

The two-year/10-year yield curve, a closely watched metric, has been inverted for two years—the longest inversion in history—currently showing a gap of minus 22 basis points (bps).

The Federal Reserve is expected to keep its benchmark overnight rate at 5.25%-5.50% for the eighth consecutive meeting when it concludes its two-day policy session on Wednesday. Investors are anticipating a "dovish hold" from Fed Chair Jerome Powell's press conference, where he might suggest that rate cuts could begin as early as September, marking the first reduction in over four years.

Powell will also use the Jackson Hole economic symposium in late August to prepare markets for a potential rate cut. By then, additional data on inflation and the July employment report could provide the Fed with the confidence to move forward.

The rate futures market now reflects expectations of about 68 bps of total cuts starting in September, up from 30 bps just before the June meeting. Analysts predict roughly three additional 25 bps cuts by June 2025.

In its June forecasts, the Fed had only anticipated one rate cut in 2024. However, easing inflation and a cooling labor market have led to a shift in expectations.

"The yield curve has adjusted significantly over the last six weeks, but it remains inverted, which is not typical," said Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors. "We expect the curve to normalize into a positive slope, and there is still considerable room for adjustment."

BULL STEEPENERS

The difference between two-year and 10-year yields has decreased by 30.4 bps since late June. Recently, the curve has mainly experienced "bull steepeners," where short-term yields have fallen more sharply than long-term yields—a common precursor to the Fed initiating an easing cycle.

Earlier this year, investors made aggressive bets on a steeper yield curve, anticipating multiple rate cuts in 2024 following a dovish pivot from the Fed in December. However, these positions reversed as short-term yields surged, flattening the curve due to a robust economy and persistent inflation.

As this week's Fed meeting approaches, futures market investors have significantly increased their long positions in short-term Treasuries, such as two-year notes, while their positions in longer maturities have either remained unchanged or declined. This reflects recent bull steepeners.

According to the Commodity Futures Trading Commission, asset managers last week raised their net long position in two-year notes to an all-time high. They have also maintained a net long position in U.S. 5-year note futures, peaking in mid-July before a slight decline.

"There is a push to position in the short end of the curve before yields decrease more noticeably," said Chip Hughey, managing director of fixed income at Truist Advisory Services.

Meanwhile, net long positions by institutional investors in U.S. 10-year futures were mostly stable last week.

"If the Fed begins its rate-cutting cycle without a recession, investing in longer bonds may not provide the same benefits as being in the short to medium part of the curve, such as the 2s to 7s," noted Mike Sanders, portfolio manager and head of fixed income at Madison Investments. The firm, managing $25 billion in assets, is currently overweight in U.S. three-year to seven-year Treasuries, anticipating that their yields will decrease.

Paraphrasing text from "Reuters" all rights reserved by the original author.