Traders are shifting their attention back to the bond trades that once caused them significant losses. This interest is particularly focused on the bet that the yield curve will return to normal as the economy slows down and central banks are forced to cut interest rates.
In the past week, the yield curve has been in the spotlight, with the yields on 10-year government bonds in the US and Europe rising significantly over shorter-term bonds. Changes in the bond market have led traders to revisit the "steepening trade," where investors go long on short-term bonds and short on long-term bonds.
As the aggressive rate-hiking cycles of the Federal Reserve and the European Central Bank draw to a close, the two-year bond bear market might be coming to an end. Olivier De Larouziere, Global Head of Fixed Income at BNP Paribas Asset Management, stated that with the major central banks globally nearing the end of their tightening cycles, everyone is reassessing the trading opportunities brought about by the yield curve inversion.
Since 2022, in an effort to control rapidly rising inflation levels, major central banks around the world have undertaken aggressive rate hikes, causing short-term government bond yields to rise above those of long-term bonds, resulting in an inverted yield curve. Many investors believe that as central banks pause or even start to cut interest rates in response to slowing economic growth, the inversion of the curve cannot be sustained in the next couple of years.
However, these trades, based on future policy changes by the central banks, are complex and hard to predict. In early July, influenced by high inflation and investor expectations of further rate hikes by central banks, the US two-year and ten-year treasury yield experienced its deepest inversion since 1981, leading traders who bet on a return of the curve to suffer heavy losses. Alexandre Caminade, Chief Investment Officer of Fixed Income at Ostrum Asset Management, stated that for many investors, betting on the normalization of the yield curve has been very painful.
In recent months, some investors have quietly returned to steepening trades in long-term bonds, betting that the yield on 30-year bonds will rise significantly compared to 10-year bonds. Anne Beaudu, a global fixed-income portfolio manager at Amundi, said they have started betting that the yield curve between 10-year and 30-year bonds will steepen further.
According to Bassi from J.P. Morgan, as economic growth slows, longer-term yield curves tend to steepen first, making 10-year government bond yields more susceptible to pressure compared to 30-year bonds. However, since policy rates rarely pivot quickly, yields on shorter-term bonds tend to remain stable.
Last week, the performance of the bond market underscored the risks of curve trades. John Williams, president of the New York Fed, said last week that inflation is decreasing as expected, and did not rule out the possibility of cutting interest rates in early 2024. Williams' comments led to a larger fall in short-term US government bond yields compared to long-term bonds.
Franck Dixmier, Chief Investment Officer of Fixed Income at Allianz, warns that investors must stay cautious; choosing the wrong moment for a trade could be very painful. Meanwhile, Caminade expressed that the opportunity to add steepening trades to a portfolio comes when we are confident that central banks have reached their final rates and begin discussing rate cuts or other easing measures.
