Until data enables the Fed to moderate the pace of its rate hikes, with another three-quarter point increase set for November, investors have tended to use front end rallies as opportunities to sell.
“Being short the front end has worked well this year and that trade still has momentum,” said George Goncalves, head of rate strategy at MUFG. “The market is still in the process of figuring out what the terminal rate will be and as you get closer to where the Fed stops, the distribution of outcomes broadens out and gets better.”
Still, some investors see reason to start wading back in, given that the steep jump in yields provides a large buffer against any future price declines. Moreover, while the Fed has already raised rates by 3 percentage points this year, the futures market is pricing in only about 1.5 percentage points more. That would put the upper bound of the Fed’s target rate at 4.75%.
“You are looking at a yield on a two year that is more than double its duration, and even if the Fed goes to 4.75% you will still do well over the next year,” said Jason Bloom, head of fixed income, alternatives, and ETF strategies at Invesco.
But Fed officials have repeatedly emphasized that they are committed to bringing down inflation that has been far more persistent than once expected. In the 2000 Treasury bear market, the 2-year Treasury didn’t rebound until after its yield crested above the peak Fed funds rate.
“People will feel a little more comfortable about the risk/reward of owning the front end if yields are near where the terminal rate ends,” said MUFG’s Goncalves.
This article was provided by Bloomberg News.