Bond traders lean into ‘sweet spot’ amid doubts over Fed path

AT BLACKROCK, PGIM and other Wall Street firms, bond fund managers are sticking to trades that will likely pay off even if the US Federal Reserve’s path is again knocked off course by surprising turns in the economy.

The run-up to the Fed’s first interest rate cut in nine months has already supplied solid returns, driving the Treasury market to its biggest annual gains since the pandemic forced the central bank to drive its lending rate to the cusp of zero.

But when Fed chair Jerome Powell finally delivered the highly anticipated move on Wednesday (Sep 17), he underscored the need to balance cracks in the job market against the risks of rising inflation.

That has strengthened conviction in what has proved a winning strategy for riding out that sort of uncertainty: buying the middle-maturity Treasuries that throw off interest payments and are more insulated from price swings caused by rapid-fire reversals to the economic outlook.

“The longer-term path is for a weaker economy and most likely lower rates to go along with that,” said Christian Hoffmann, portfolio manager at Thornburg Investment Management. But, he said, there’s a lot of uncertainty because it’s “increasingly difficult to draw a straight line from the evolution of the data to the Fed’s reaction”.

Treasuries traded little changed on Monday, underperforming a small rally in UK and European government bonds. Yields on five-year US notes steadied at 3.68 per cent.

The case for the Fed’s shift back to cutting rates has been supported by a steep slowdown in the pace of hiring over the past several months as businesses braced for the impacts of US President Donald Trump’s trade war.

But at the same time, other elements of the economy have held up and the president’s tariff hikes threaten to rekindle inflation that’s already stubbornly above the Fed’s 2 per cent target.

At his press conference last Wednesday, Powell characterised the Fed’s quarter-point move as “a risk management cut” and said policymakers would be taking things “meeting by meeting”, even as their forecasts indicated two more reductions are likely this year. The comments dragged on the bond market, pushing yields up across maturities through the end of the week, by dashing some speculation that it was poised to usher in a more aggressive series of cuts.

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Russell Brownback, the deputy chief investment officer of global fixed income at BlackRock, said dynamics favour a focus on the so-called belly of the yield curve, or those maturing around the five-year range. That’s been one of the strongest performing segments this year, with a Bloomberg index of five- to seven-year Treasuries returning roughly 7 per cent, beating the broader market’s 5.4 per cent gain. “The belly is the sweet spot,” he said.

Greg Peters, co-chief investment officer at PGIM Fixed Income, echoed that sentiment. He said the fixed interest payments on those securities are high enough to make a profit by using borrowed money to purchase them, in what’s known as positive carry. They also provide capital appreciation as the securities get closer to maturity. “Positive carry and roll: it’s the bond investor’s dream,” he said.

The approach provides something of a buffer from the risk that a jump in inflation or stronger-than-expected economic data will cause the Fed to change tack. Already, the Fed’s updated rate forecasts showed a wide dispersion of views.

Overall, it indicated they largely expected to cut rates over the next two meetings, with single quarter-point reductions pencilled in during 2026 and 2027, a less aggressive path than what has been priced into the futures market.

That backdrop sparked some to unwind their pre-cut rally trades, with the strategy team at Natixis SA closing a long recommendation on two-year Treasury notes on Thursday.

Andrew Szczurowski, a portfolio manager at Morgan Stanley Investment Management, said the market’s current pricing may well be more accurate than the Fed’s forecasts. He said he anticipates that the Fed will err on the side of protecting the labour market by continuing to dial down borrowing costs, providing some room for the bond market to extend its gains.

Szczurowski, whose US$12 billion Eaton Vance Strategic Income Fund returned 9.5 per cent this year, beating 98 per cent of its peers, said he’s been telling clients that “you missed some of the rally, but there’s still upside”.

“It’s a bond picker’s market,” he said.