Longer-term debt appears safer even if Fed raises interest rates soon

New York

WHILE debate rages over whether the Federal Reserve will raise interest rates this month, bond strategists seem to agree that longer-term Treasury securities look less vulnerable than short-term ones, and they're seeking ways to profit no matter what the Fed does.

Even as traders have pared back bets that policy makers will increase rates at their Sept 16-17 meeting, the prospect of a Fed move pushed yields on shorter-term Treasury notes to the highest since 2011 the last week. That has strategists focusing on a flattening trade, in which investors bet the yield difference between shorter- and longer-term notes will narrow - flattening the shape of the curve between them.

"The front end will underperform," said Bruno Braizinha, director of rates strategy in New York at Societe General, one of 22 primary dealers that trade with the Fed. "It makes sense given the event risk ahead." Mr Braizinha expects the Fed will lift rates this month.

Traders are lured by longer-term debt as inflation remains tame. A report on Friday showed wholesale prices in the US were little changed in August, signalling that price gains may remain weak and below the Fed's 2 per cent goal for a while.

"It's just safer to own the long end and continue to buy dips on 10s on out," said Guy Haselman, strategist at Bank of Nova Scotia. "The front end is being pulled by a gradual Fed." Traders have lightened up on shorter-term securities, sending the two-year note yield to 0.76 per cent on Sept 9, the highest since 2011. Rates on six-month bills touched 0.27 per cent on Sept 9, the highest since 2009.

At the same time, yields on longer-term securities have trailed forecasts for higher levels. The yield on the 10-year note on Friday traded at 2.12 per cent, versus the 2.48 per cent year-end forecast in a Bloomberg News survey. The 30-year bond yield traded at 2.95 per cent, versus the year-end forecast of 3.16 per cent.

Societe General recommends investors bet on a narrowing spread between five-year and 30-year yields. That gap declined to 1.44 percentage points on Friday, after reaching a 2015 high of 1.57 percentage points in July. Investors can bet the shape of the yield curve will flatten by buying a longer-dated security and selling a shorter-dated one.

The flattening strategy can work well even if the Fed doesn't raise rates this month, said Priya Misra, the head of global interest-rates strategy at TD Securities in New York. After the central bank's decision on Sept 17, "the Fed's message could be perceived as hawkish as it keeps hopes of a late-2015 hike alive", she wrote in a note.

TD Securities is also recommending a similar trade even though it expects the Fed will wait until March to raise rates.

Futures traders have reduced bets for a September Fed liftoff, with the probability at 28 per cent on Friday from 32 per cent on Sept 1. The calculation is based on the assumption that the effective fed funds rate will average 0.375 per cent after the first increase. BLOOMBERG