Bond investors expect the Federal Reserve to keep interest rates unchanged this week but signal an imminent rate cut, so they are betting that the U.S. yield curve will become less inverted and eventually return to normal.

The strategy involves taking bullish bets on short-term Treasuries and reducing exposure to longer-term Treasuries, a trade known as yield curve steepening that has the effect of pushing yields on longer-term Treasuries above those on shorter-term Treasuries. Investors are compensated for taking on risk for a longer period of time by receiving higher yields.

The much-watched two-year/10-year U.S. Treasury yield curve has been inverted for two consecutive years, the longest inversion in history, and the current yield gap between the two is negative 22 basis points.

The market generally expects the Fed to keep its overnight benchmark interest rate unchanged at 5.25%-5.50% for the eighth consecutive time on Thursday. Investors expect Fed Chairman Powell to give a "dovish" signal of holding back at the press conference after the meeting, that is, he may hint that he will start to cut interest rates as early as September, which will be the first rate cut in four years.

Powell also has a chance to prepare markets at the Jackson Hole global central bankers' gathering in late August. By then, more data on inflation and Friday's July jobs report could give policymakers the confidence they need.

Interest rate futures markets have priced in a total of about 68 basis points of rate cuts from the Fed starting in September, a sharp increase from the 30 basis points before the June meeting, according to calculations by the London Stock Exchange Group (LSEG). About three more 25 basis point cuts are expected by June 2025.

In the Fed's June rate forecast, the central bank only expected one rate cut in 2024. Slowing U.S. inflation and a gradual loosening of the labor market have prompted a shift in market interest rate expectations.

Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors, said: "The yield curve has changed significantly in the past six weeks, but we were at a similar level last October, and an inverted yield curve is still not normal. We are entering a situation where Scenario, the yield curve will move toward its normal positive slope. "It has a lot of room for change." The company has $352.6 billion in assets under management.

The spread between two-year and 10-year Treasury yields has narrowed by 30.4 basis points since the end of June. In recent weeks, the yield curve has mainly experienced a "bull steepening," in which short-term Treasury yields fall more than long-term Treasury yields, a classic precursor to the Fed starting a rate-cutting cycle.

Investors in January were aggressively betting on a steeper yield curve as markets priced in multiple rate cuts in 2024 in response to the Fed’s dovish shift in December. However, those bets were subsequently reversed and the yield curve flattened further as short-term Treasury yields surged above long-term Treasury yields, citing unexpectedly continued economic strength and stubborn inflation.

Before this week’s Federal Reserve meeting, investors in the futures market significantly increased their net long positions in short-term U.S. Treasuries (such as two-year U.S. Treasuries), while their net long positions in long-term U.S. Treasuries did not increase accordingly, and even dropped. This is consistent with the "bull steepening" strategy implemented over the past few weeks.

Data released by the U.S. Commodity Futures Trading Commission on Friday showed that asset managers increased their net long positions in two-year Treasury bonds to an all-time high last week. Asset managers have also been holding a net long position in five-year Treasury futures, which reached an all-time high in mid-July, although it fell slightly last week.

“There’s a lot of urgency to get to the short end of the yield curve quickly before yields start to move lower in a more pronounced way,” said Chip Hughey, managing director of fixed income at Truist Advisory Services.

“If the Fed starts a rate-cutting cycle without a recession, buying any maturity or any long-dated bond won’t necessarily give you the same returns as betting on two- to seven-year Treasuries,” said Mike Sanders, portfolio manager and head of fixed income at Madison Investments, which has $25 billion in assets and is currently overweight three- to seven-year Treasuries, reflecting its expectation that yields on those bonds will fall.

Article forwarded from: Jinshi Data