European institutional investors wishing to capitalize on anticipated rate cuts by the Federal Reserve are turning to curve steepeners. Strategists at BNP Paribas and Amundi said this strategy is rapidly becoming a no-brainer trade.
Expectations for a rate cut in September stand at around 95 percent, according to the CME Group’s FedWatch Tool, with most investors anticipating another reduction in December.
Assuming these predictions hold, European managers of global bond portfolios now favor curve steepener trades. This involves buying short-term U.S. government bonds while shorting longer-term bonds to profit from the widening gap between short- and long-term interest rates.
“When Fed rate cuts are imminent, buying short-term bonds and shorting longer-term bonds becomes a high-conviction trade.”
Daniel Morris, BNP Paribas Asset Management
Daniel Morris, chief investment strategist at BNP Paribas AM, acknowledged that while curve steepeners might not be “very original,” they “should work.” The strategy is particularly attractive for investors uncertain about the yield curve’s reaction.
“When Fed rate cuts are imminent, buying short-term bonds and shorting longer-term bonds becomes a high-conviction trade, even if your prediction for the long end of the curve isn’t entirely accurate,” Morris told Investment Officer.
Market dynamics: short-end yields have more potential to decline
The yields on Treasury bills and short-term bonds, such as two-year Treasuries, are closely tied to the federal funds rate. These yields typically decrease quickly in response to rate cuts or the expectation of imminent cuts. While this hasn’t happened yet, investors expect the short-term bond premium to react more to rate cuts than long-term bond yields.
Data from the Commodity Futures Trading Commission shows that asset managers’ long positions in two-year Treasury futures have hit an all-time high this month. Conversely, their bullish positions on 10-year note futures have decreased by about 10 percent year-over-year.
The renewed interest in steepener trades coincides with the second anniversary of the inverted yield curve, a traditional predictor of economic downturns. Since mid-2022, the market has demanded higher yields on shorter-term bonds than on longer-term ones.
Spread between 10-yr and 2-yr Treasuries still negative
The interest rate environment in 2023 illustrated that the unwillingness of institutional investors to bet on duration is justified. Despite several rate hikes totaling 100 basis points by August, most rates across the yield curve ended the year near their starting points.
Term premium is back
The U.S. Treasury Department’s increased issuance of short-term Treasury bills has raised interest payments, leading investors, including Pimco, to believe that yield curve normalization will occur primarily at the front end.
But even investors who expect minimal changes in the short part of the curve are turning to steepeners. Gilles Dauphiné, deputy head of Amundi’s Alpha Fixed Income platform, has shifted from short duration positions to neutral, focusing on steepening positions in two-year and five-year bonds versus 30-year bonds.
“This strategy bets on a decrease in short-term rates and the return of the term premium to long-term averages,” Dauphiné told Investment Officer.
“With the future path of interest rates becoming clearer and reducing volatility, we have also maintained an overweight duration in credit, especially in the banking sector, where we believe fundamentals are strong for well-rated companies,” he added.
US fiscal uncertainties remain
Despite optimism about upcoming rate cuts, fund managers remain cautious about long-term investments. Major asset managers including BlackRock and Vanguard are avoiding long-term Treasuries, fearing that fiscal uncertainties could cause volatility.
Increased government spending in the U.S. might offer opportunities to buy long-term bonds at good prices. However, the market is expected to demand higher premiums for these bonds due to the anticipated surge in government debt issuance.
This expectation is supported by the Congressional Budget Office’s recent increase in its deficit forecast for 2025-2034, now at 22.100 billion dollars, up 2100 billion dollars from the previous estimate.
Projections show that federal debt could reach nearly 50.000 dollars by 2034, up from 34.000 billion dollars this year. This potential increase in debt issuance supports the expectation of higher premiums.
Investors are eagerly awaiting the next U.S. Treasury refunding announcement on July 29, which could provide more details on the government’s borrowing plans and their impact on bond markets.