Investors in the US Treasury market are shifting their focus to owning shorter-dated government bonds, a bet that the Federal Reserve will eventually emerge victorious in its fight against inflation.
Two-year yields have soared to a multi-year high of around 4.75% in the days following the Fed's first
Bullish investors are confident that the battered two-year's price already reflects those increases and could roar back if inflation improves or the Fed raises rates less than expected. Such bets were already proliferating a day after the Fed meeting, with demand surging for options that would benefit from a decline in the Secured Overnight Financing Rate, which is closely tied to policy expectations.
"If you were to look at any part of the curve right now and ask where is there a potential overshoot in yields, it looks like the front-end," said Kevin Flanagan, head of investment strategy at WisdomTree. "The two-year is trading well above the current Fed funds rate and that suggests the front-end has moved too far ahead."
Yields on two-year Treasuries — typically seen as the most sensitive to Fed policy — have already risen by around 140 basis points from their February lows, when the market was positioned for cuts, rather than hikes. At around 4.72%, they now stand far above the new Fed rate setting of 3.75% - 4%, with the bond market running well ahead of central bank officials, who expect one more increase this year followed by a steady policy setting for 2027.
Proponents of the trade also note the tenor is less subject to the violent price swings that can grip the longer end of the curve while offering holders its richest yield since 2024.
"Our message to our clients is that now is a good time to add duration out into the intermediate part of the curve," said George Bory, chief investment strategist of fixed income at Allspring Global Investments.
The firm boosted its bond holdings following Warsh's Jackson Hole
Investors are expecting a $69 billion sale of two-year notes on Tuesday to offer a snapshot of demand for shorter-dated debt, followed by a $70 billion auction of five-years on Wednesday. Among leading Fed officials speaking this week are New York president John Williams and Cleveland president Beth Hammack, a noted hawk on inflation.
Of course, there are several risks that can upend the trade. With little end in sight to wars in the Middle East and Ukraine, elevated energy prices could stoke further inflation and lift expectations for how much higher the Fed will need to raise borrowing costs. So can a US economy that proves stronger than expected.
Strategists at Bank of America Corp. said investors should
"The question is how do you get confidence about where the terminal Fed rate is a year from now," said Ed Al-Hussainy, portfolio manager at Columbia Threadneedle Investments, "The risk is that in every hiking cycle, the market has underestimated how much the Fed ends up doing."
Still, oil prices have shown a tendency to drop on signs of an Iran deal or news on improved flow of crude through the war-torn region. At the same time, some market participants say that the bond math currently works in favor of investors looking to hold for the longer-term.
At around 4.75%, the two-year yield provides an income that exceeds even the market's current estimate of the Fed pushing its rate to 4.68% by September 2027, via swap contracts that track future central bank meetings.
"The place where you could create the most coherent argument in terms of where there's real value is at the front end," said Trevor Slaven, head of multi-asset portfolio solutions at Barings. "This pricing of another three hikes looks a low probability event."
