Investors shifted focus to shorter-maturity debt after the Federal Reserve's latest dovish stance on monetary easing, driving Treasury yields down and setting sights on record highs for stocks despite lingering economic and earnings uncertainties.
Signaling a pause in hikes, the Fed kept rates steady at last week's Federal Open Market Committee (FOMC) meeting at 5.25 to 5.5 percent and hinted at lower borrowing costs in 2024. Chairman Jerome Powell acknowledged inflation could bring back hikes, but its focus had shifted to potential rate cuts.
The Fed is projected to make at least three cuts, around 75 basis points, pushing it from 5.1 percent in September 2023 to 4.6 percent by the end of next year. It also projected the rates to drop to 3.6 percent by 2025 and 2.9 percent by 2026. Meanwhile, LSEG data indicated futures pricing at a rate of 3.847 percent for the Fed's policy rate.
Now, the market waits for further announcement of the cut timeframe. After New York Fed President John Williams said it was "too soon" to talk of a potential rate cut by March, yields went up, but buyers swooped in, leaving rate cut bets largely unchanged. The market still eyes early cuts, with an 80 percent chance of action by March and 1.64 percent easing priced in by year-end.
"In light of the faster return to target, we now expect the FOMC to cut earlier and faster," Goldman Sachs' top economist Jan Hatzius said.
"We now forecast three consecutive 25 basis point cuts in March, May, and June to reset the policy rate from a level that the FOMC will likely soon come to see as far offside, followed by quarterly cuts to a terminal rate of 3.25 to 3.50 percent, 25 basis points lower than we previously expected."
Why do investors turn to short-term debts?
Waning recession fears are injecting optimism into the short-term debt market, as investors fear returns on cash-like investments will nosedive with the government getting ready for a soft landing. According to Bloomberg, a sizable chunk of the $6 trillion parked in money-market funds is poised to be moved to the two-year Treasury notes (T-notes). It offers a 4.4 percent yield higher than any other maturity.
The appeal of the two-year note becomes apparent when examining the yield curve, as long-term rates have traded below shorter-term debt for over a year. Traders are also worried about the perceived increased risk associated with these bonds, including ongoing high U.S. government deficit funding through continuous issuance.
Currently, the yield on the 10-year note sits approximately 50 basis points lower than the yield on two-year maturity debt. Just a few months ago, in July, this difference was over 100 basis points.
Many investors are now betting on a reversal to the conventional pattern of the curve in the coming year. This shift could trigger a significant outflow from money-market funds, reshaping the landscape of fixed-income investment in the months ahead.
"The Fed gave us their 2024, 2025 expectations for where rates go, and they go lower," said Lindsay Rosner, a portfolio manager at Goldman Sachs Asset Management. She advised investors to aim for "a mixture of two and fives [T-notes]" as longer-maturity bonds might not be "where we see much value."
Bloomberg's Instant Markets Live Pulse survey following the Fed meeting revealed that 68 percent of respondents predicted a positive curve shift in the second half of 2024 or later. Meanwhile, 8 percent anticipated this change in the first quarter, while 24 percent expected it in the second quarter.
Major investors like Jeffrey Gundlach from DoubleLine Capital LP, Bill Gross (formerly known as the bond king at Pacific Investment Management Co.), and billionaire investor Bill Ackman also forecast a curve reversal.
Gundlach foresees the 10-year yields dropping towards the low 3.0 percent range next year, while Gross and Ackman anticipate a potential positive slope emerging by the conclusion of 2024.