Treasury Traders' World Looks Flat as Fed Signals Gradual Pace

  • Spread between two- and 10-year yields is smallest since April
  • U.S. scheduled to auction two-year securities on Nov. 23

The U.S. bond market is sending a clear message: Traders expect the Federal Reserve to raise interest rates soon, and slowly.

Thirty-year Treasuries posted their first back-to-back weekly gains since August as sinking oil prices and the prospect of imminent Fed liftoff dimmed inflation prospects. In the minutes of the Fed’s October meeting, which the central bank released this week, officials indicated it may be appropriate to raise rates from near zero in December and to proceed with caution thereafter.

Yields on two-year debt, the note that’s most sensitive to Fed moves, rose this week. As a result, the extra yield on 10-year Treasuries over two-year obligations shrank to 1.34 percentage points, the smallest gap since April. The dwindling spread -- a flattening of the yield curve in bond-world parlance -- can indicate traders are confident economic growth and inflation will remain tame.

"Even if they hike in December, the market and the Fed seem to be confirming a very gradual -- a very data-dependent path -- of rate hikes," said Subadra Rajappa, head of U.S. rates strategy in New York at Societe Generale SA. "The key takeaway was the fact that they’re going to have a very shallow path of rate hikes after liftoff."

Thirty-year yields fell three basis points this week, or 0.03 percentage point, to 3.02 percent, according to Bloomberg Bond Trader data. The price on the 3 percent security due in November 2045 rose about 5/8, or $6.25 per $1,000 face amount, to 99 19/32. The benchmark 10-year note yielded 2.26 percent, little changed this week.

Sensitive Maturity

Longer maturities, which are more sensitive to inflation, are rebounding after yields touched three-month highs following a Nov. 6 report showing surging U.S. job growth. Even with the labor-market strength, the central bank’s preferred price-growth gauge has been below its 2 percent goal since 2012.

Sliding commodities prices are suppressing inflation expectations. Oil has slumped almost 50 percent in the past year, dipping below $40 a barrel this week for the first time since August.

With investor bracing for a Fed increase, long-term Treasuries should outperform shorter-term debt, David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC, wrote in a note Friday.

Traders are pricing in a 68 percent probability that the Fed will lift its benchmark from near zero in December, and are signaling that the fed funds rate will still be below 1 percent in a year. The calculations are based on the assumption the effective fed funds rate will average 0.375 percent after liftoff, compared with the current range of zero to 0.25 percent.

Two-year Treasury yields held close to a five-year high with the Fed’s policy decision looming on Dec. 16, and as the U.S. plans to sell $26 billion of the maturity on Nov. 23.

"Most of the pressure’s going to come on the short end, as it should in an environment where the Fed’s going to tighten in a period where inflation is low," said Bob Andres, chief investment officer of Berwyn, Pennsylvania-based Andres Capital Management, which oversees $800 million.

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