One crucial inflation number will help determine the fate of the bets. Bets that the U.S. yield curve will normalize toward a steeper curve suddenly look as good as they have in months.
President Biden got an initial boost when his performance at the June 27 debate appeared to pave the way for Donald Trump to return to the White House. In the aftermath, strategists at banks including Citigroup, JPMorgan Chase & Co. and Morgan Stanley touted the so-called Trump trade. The idea is that Republican policies on tariffs, immigration and deficits will lead investors to demand higher yields on long-dated Treasuries.
New signs of a weakening job market bolstered expectations that the Federal Reserve will cut rates this year, pushing short-term Treasury yields sharply lower. A closely watched yield curve indicator -- the difference between 5-year and 30-year Treasury yields -- reached its widest level since February after the data was released.
The Fed's accommodative policy is seen as the main driver of bets on a steeper curve, which has sharpened the market's focus on inflation data due this week.
Consumer prices likely rose at the slowest pace since January, a survey showed. Further evidence of disinflation could remove a major obstacle to a successful steepening plan: Fed officials have been signaling they are not ready to cut rates.
“The steepening trend due to inflation and fiscal policy will continue,” said Cindy Beaulieu, chief investment officer for North America at Corning.
The trade was also a hot topic in the market at the beginning of the year as investors bet on the Fed to cut interest rates as they head into 2024. However, a recovering economy and firming inflation have dashed bets on easing. When the U.S. bond market closed on June 27, hours before the debate, the gap between 5-year and 30-year bond yields narrowed by about 5 basis points from the year end. In other words, the trade is a failure.
While political developments sparked its recovery, a more sustainable move would require the Fed to cut rates sharply. That would drop short-term yields more than long-term ones, producing what traders call a bull steepening move.
Strategists Ira Jersey and Christopher Cain said, "While the Treasury yield curve may continue to steepen in the near term, we believe the recent bear market steepening may quickly turn into a bull market steepening once the Fed begins a rate cutting cycle...While there are periods of flattening in both bull and bear markets, the large swings in the curve are associated with volatility at the front end, suggesting that Fed policy is key to the direction of the yield curve."
But there are few signs of a recession of such magnitude that the Fed will immediately rescue it. Policymakers also do not seem confident enough that inflation will be sufficiently cooled.
"When we look at recent employment and inflation data, we do not believe that a big rate cut is needed this cycle," said Baylor Lancaster-Samuel, chief investment officer at Amerant Investments Inc. "There is certainly a risk that the Fed continues to keep rates at restrictive levels until 2025. Therefore, the risk is that we do not get such an aggressive bull market soon."
Strategists at Goldman Sachs Group Inc. are also skeptical of a steepening yield curve. They expect the 5- to 30-year yield curve to be roughly flat with current levels in the fourth quarter.
Strategist Bill Zu noted that yields fell and the curve flattened when Trump launched a trade war with China during his presidency as tariffs weighed on productivity and growth.
In addition, the relatively small difference in the outlook for U.S. deficits under the two candidates’ policies suggests that any supply-driven repricing of yields based on election results should be “modest at best.”
TD Securities strategists, on the other hand, expect the spread between 5-year and 30-year bond yields to eventually quadruple to 100 basis points from here. Fed rate cuts are integral to that forecast, which the bank has stuck with since last year. But the threat of high deficits also exists regardless of which party wins in November, TD Securities’ Gennadiy Goldberg and his team wrote late last month.
Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors, said he is “modestly” allocated to a steeper curve, overweight 5-year bonds and underweight longer-dated bonds. He said economic conditions will be the primary trigger for the strategy, not politics.
"We hope to see data that increases the likelihood of a soft landing and that the Fed can start cutting rates," he said. "That's good news for investors who are steepening rates."
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2024-07-08
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