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Yields stabilising: Traders on the floor of the New York Stock Exchange. The five-year maturity, unlike the two-year note, is seen as a proxy for the broader economic outlook. — AFP
WASHINGTON: Some of the biggest bond managers are zeroing in on one specific area of the market as the best place to ride out the early days of the Federal Reserve (Fed) chairman Kevin Warsh era.
From Capital Group to Insight Investment, Natixis and Pacific Investment Management Co, the message is the same: The sweet spot is the “belly,” or the five-year area of the Treasury curve, and they’re all piling in.
Investors are gravitating to those maturities as Treasury yields stabilise after spiking earlier this month on Warsh’s hawkish pronouncements on restoring price stability.
Rebounding from those losses, US bonds notched steady gains last week as oil prices declined and traders ratcheted back some of their more aggressive wagers on interest-rate hikes for this year into 2027.
“The five year is a nice balance” and a “good pivot point,” said Brendan Murphy, head of fixed income for North America at Insight Investment, a global asset manager with some US$836bil under management.
With Fed officials split over whether to stay on hold or hike at least once this year, the five-year maturity appeals because it’s seen as a proxy for the bigger economic picture, taking in a longer period that can include both easing and hiking cycles.
That’s unlike the two-year note, which is primarily driven by shorter-term rate wagers.
And it carries less risk than inflation-sensitive long bonds, while still offering a generous yield, at 4.13% as of last Friday.
Buyers of the belly say they are mindful that the bond market narrative is fluid and prone to shifts. Rate cuts could easily re-enter the conversation even though hikes have been the main topic lately.
Already, activity in the past week shows traders toning down their hawkish stance, pricing in one to two rate increases by the middle of next year as a peak for Fed tightening after earlier positioning for a series of hikes starting as early as next month.
Intermediate maturities around the five-year area may also offer shelter from any volatile reactions to upcoming data, such as the June monthly jobs report last Thursday, followed by inflation prints next month.
“The front end of the curve will be more volatile, which is why I prefer intermediate rates,” said Chitrang Purani, a portfolio manager at Capital Group, which has more than US$3 trillion under management.
“The inflation trajectory and growth resilience that we’ve seen year-to-date does justify the move higher in interest rates, but looking forward, the drivers of economic growth remain uneven and inflation has not yet been led by demand-side factors.”
Another selling point for the belly? It’s a relative bargain, as highlighted by a measure that shows five-year notes have underperformed both shorter- and longer-dated maturities.
The so-called butterfly – a gauge of where the five-year Treasury yield stands relative to its two- and 30-year counterparts – is trading near its highest level in more than a year.
Even as traders trimmed back their pricing of rate hikes in recent sessions, there remains a wariness that should forthcoming data show inflation isn’t moderating - it’s been running above the Fed’s target for years now — the central bank will likely push through hikes starting as soon as September.
The pressure in Treasuries will be led by the policy-sensitive two-year, with longer-dated yields likely to lag as the prospect of tighter Fed policy is seen prompting weaker growth in 2027.
“If the Fed hikes in 2026, they unwind later in 2027,” said John Briggs, head of US rates strategy at Natixis North America.
As a result, he said he prefers the “belly a bit more to get a bit more of time to price in the potential cuts.”
It’s a view recently endorsed by PGIM, with the asset manager expecting three hikes this year, followed by a series of eases in 2027 into 2028.
“Five-year Treasuries sit at the intersection of Fed policy and inflation expectations. As such, recent price action reflects confidence in a fading energy shock at the same time as the view that inflation can moderate without a meaningful deterioration in growth gains traction,” said Alyce Andres, macro strategist, Markets Live.
Other investment houses have largely stuck to their calls even as market pricing turned more hawkish.
For bond giant Pimco, that includes positioning in the belly.
“Our base case disagrees with the market as we don’t believe that the Fed will raise rates because the economy should slow in the second half of this year and buy time for them to stay on hold,” said Michael Cudzil, a senior portfolio manager with Pimco.
The US$2.3 trillion asset manager is overweight interest-rate exposure and owns both the front end and the belly, or twos through fives – an area Cudzil says has only grown more attractive after the recent selloff.
“It’s very possible that front end and belly yields fall below 4% in the second half of the year, if the market takes out hikes and then starts talking about potential easing,” he said. — Bloomberg
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