What was supposed to be the darling trade of 2024 has unraveled, thanks to the Federal Reserve upending predictions over how fast it would lower interest rates.
The market entered January aggressively betting on sharp rate cuts. By doing so, traders looked to profit from the US Treasury yield curve returning to a traditional upward slope, a transition known as a steepener. That would put longer-dated yields back above their short-term equivalents, reflecting the usual need to be compensated for risk over time.
Bill Gross, the co-founder of bond giant Pacific Investment Management Co., has been assuming such steepening would occur for nearly two years. When Goldman Sachs Asset Management rolled out its 2024 investment outlook, it declared the steepener, or the return to normality, the “easiest trade out there in rates.”
Such calls have backfired as short-term yields went even further above long-term ones as a resilient economy and sticky inflation led Fed officials to push back hard against market speculation cuts would begin in March.
Now, traders see the Fed’s first shift coming in June or possibly July, with total rate reductions for all of 2024 adding up to just slightly more than three-quarters of a percentage point. Those dynamics served as a headwind to the steepener trade, prompting a market-wide rethink.
At the height of January’s rate-cut speculation, Kellie Wood, deputy head of fixed income at Schroders Plc in Sydney, said her firm backed off its steepener bets. Schroders is now modestly short Treasuries as it awaits the US economy weakening, which would encourgage the yield curve to finally steepen
“The longer the Fed keeps rates restrictive, the more confident we get that growth will moderate at a time when inflation is within target,” she said.
A key measure of the shape of the yield curve is the spread between the rate on two-year Treasury notes versus those with ten years to maturity. At present, the shorter tenor is about 40 basis points higher than the longer — an inverted curve, in bond speak.
Earlier this year, it looked like this steepener was paying off as that gap fell to as little as 16 basis points as the yield curve became less inverted in anticipation of rate cuts coming as soon as March. During the Fed’s tightening cycle last March, the inversion reached over 100 basis points, its most extreme since the 1980s. Such inversions have telegraphed the last eight recessions.
Sticking to your guns when your bets aren’t paying off is always tough. Yet, for traders, the added bad news is that with the yield curve turning upside down, holding the steepener position would lead to a slow bleed of losses, even if yields remain unchanged. That’s because of the cost of “carry,” or the price of holding bond positions and then rolling them into new ones over time.
For example: With a typical two-year and 10-year steepener trade, such carry costs amount to a loss of 40 basis points a year, assuming no other changes. This means an investor who initiated the trade a year ago and held onto it would have barely made any money, despite the fact the curve moved in the right direction and steepened about 50 basis points during the period.
So for the trade to work, Fed rate cuts have to come sooner than later, Ben Emons, a senior portfolio manager at Newedge Wealth, explained. “If there’s no rate cuts, steepening is just not going to happen. It’ll just fizzle out,” he said.
The Fed left policy rates unchanged in a range of 5.25% to 5.5% last month. They have hoisted rates up by over five percentage points from near zero when they began the tightening cycle in March 2022. Swaps contracts that try to predict the central bank’s decisions are now roughly in line with what Fed officials signal in their last quarterly rate projections in December.
What Bloomberg’s Strategists Say...
“If the economy properly rolls over, recession becomes a base case in the relatively near future, and inflation dynamics are dovish enough that the Fed can execute a swift handbrake turn on policy, then the curve can steepen in a hurry, outpacing the forwards. Unless that happens, however, those holding steepeners, or even naked longs in short-dated coupon bonds, have to confront the fact that Dr. Market sends a hefty bill every month.”
— Cameron Crise, macro strategist
GSAM’s Ashish Shah said the firm put its wager last year in the interest rates swaps market. It’s a bet on how the forward market is pricing the curve two years into the future. The advantage is that this dims the negative carry effect while making the position less linked to exactly when the Fed begins cutting rates.
“We do still like the steepener,” Shah said, adding that inflation “may not be coming down in a straight line, but it is coming down.” While the firm still sees a soft landing, in the event of a sharp slowdown, “the steepener really does very well.”
Barclays in its rates weekly last week also recommended the steepener, while Citigroup’s bond strategists published a report on Friday with the title “The pain trade is the flattener.”
Gross said history favors the steepener trade. Not since the days of Paul Volcker’s massive hikes to break double-digit inflation has the curve stayed inverted as long as it has now. Gross is holding firm to his position that steepening occurs between two- and 5-year Treasuries.
“Capitalism cannot thrive with a negative curve,” Gross said. “It cannot forever provide a Treasury with a higher yield and a shorter duration.”
The two- and five-year yields trade at about 4.71% and 4.32%, respectively. Meanwhile, benchmark 10-year rates are 4.31% and Treasuries with 30 years to maturity yield around 4.44%.
Vineer Bhansali, founder of LongTail Alpha LLC who’s also betting on a steeper curve, points out that there’s negative carry in most assets. Most stocks, for example, offer average dividend yields at about 2.5%, far below the over 5% fed funds rate, according to his estimate.
“There’s really about no investment you can do right now betting on a return to normalcy that has positive carry,” Bhansali said. “And yeah, when the curve flattens you get hurt and you are paying annually about 50 basis points in carry, but it’s worth it. You just need to be able to hold it.”
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