U.S. bonds are on best run since March

Treasuries are set to book a fourth-straight week of gains – the best winning streak since March – on building investor confidence that the Federal Reserve will begin cutting interest rates next quarter.

Rates oscillated Friday amid light pre-holiday trading after a report showed the Fed’s preferred gauge of underlying inflation barely rose in November, endorsing a growing narrative that central bankers have successfully broken the back of price pressures and will aggressively ease monetary policy in 2024.

That zeitgeist has prompted money managers to pile into Treasuries in recent weeks, with Citigroup Inc. describing positioning as now “at extremes.”

Swaps contracts tied to Fed meetings imply an over 90% probability the U.S. central bank brings down its current 5.25% to 5.5% target rate range down in March.

Across 2024, traders are penciling in nearly 160 basis points of rate reductions – more than twice as much as Fed officials signaled earlier this month in their new round of quarterly forecasts.

“The slowest rate of year-over-year core inflation in almost three years cements the next macro question on the timing of the cut from the Fed – even if we maintain a Q1 move lower in the target band is too soon,” BMO Capital Markets strategist Benjamin Jeffery said in a note.

While a separate report on durable goods orders came in well above estimates, encouraging some position squaring, that wasn’t enough to meaningful shift rate expectations.

The rate, hovering now at about 3.91%, has declined well over a percentage point since touching a 16-year high in October of 5.02%.

Two-year yields, slipped marginally Friday to around 4.34%, after reaching a cycle high in October of 5.26%.

Bonds resurrected

Treasuries have gained 3.7% this year through Dec. 21, an abrupt turnaround from just a few months ago when it looked like US government debt was headed for an unprecedented third year of annual losses, Bloomberg index data show.

U.S. Treasuries lost 12.5% last year and 2.3% in 2021.

However, a $155 billion round of fresh fixed-rate note and bond sales next week may temper the extent of any further decline in yields before year-end.

The U.S. Treasury will sell $57 billion of 2-year notes on Tuesday, followed by $58 billion of 5-year notes the next day, and $40 billion of 7-year debt the following day.

“Illiquid holiday markets and some selling pressure ahead of next week’s auctions” kept yields in check Friday, said Thomas di Galoma, co-head of global rates trading at BTIG.

And while the ebbing of inflation is positive for the Fed, strong income figures that were also part of Friday’s data report may help fuel consumer spending – working against the U.S. central bank’s aim to slow the pace of economic growth.

That poses risks for the bond market heading into the new year and could derail its winning streak.

Traders have been wrong-footed many times in the past by pricing in too quick and sharp a shift to monetary easing.

And, as noted by Citi, a continued adding to Treasury long positions leaves a big risk to these bullish positions coming from any steepening of the yield curve.

Bloomberg’s monthly survey shows the median expectation is for the U.S. central bank to reduce the benchmark rate by 25 basis points at the June 2024 policy meeting, followed by three more cuts in the second half of the year.

“We’re getting to the critical juncture,” Michael Kushma, CIO of fixed income at Morgan Stanley said on Bloomberg Television.

“We know interest rates are coming down in 2024. We don’t know how much, but it will be meaningful.”