Bond Strategists' Favored Trade Seen a Winner Whatever Fed Does

  • Dealers expect longer-term Treasury securities to outperform
  • Two-year note yields touch highest levels since 2011

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 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.” Braizinha expects the Fed will lift rates this month.

Traders are lured by longer-term debt as inflation remains tame. A report Friday showed wholesale prices in the U.S. were little changed in August, signaling that price gains may remain weak and below the Fed’s 2 percent 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.”

Yield Curve

Traders have lightened up on shorter-term securities, sending the two-year note yield to 0.76 percent on Sept. 9, the highest since 2011. Rates on six-month bills touched 0.27 percent 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 percent, versus the 2.48 percent year-end forecast in a Bloomberg News survey. The 30-year bond yield traded at 2.95 percent, versus the year-end forecast of 3.16 percent.

Societe General recommends investors bet on a narrowing spread between five-year and 30-year yields. That gap declined to 1.44 percentage points 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 percent on Friday from 32 percent on Sept. 1. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.