CIO continues to believe interest rates will decline by year-end, but trims some of its exposure, as the market is currently pricing in 60bps of Fed rate cuts in 2025. (UBS)
CIO implemented a five-year Treasury long on 7 November as interest rates rose following the election. At that time, however, our expectation was for the Fed to cut 100bps in 2025. As growth proved more resilient, fueled by a strong labor market and sticky inflation, expectations of the future Fed terminal rate path began to rise. Since then, the consistent talk of tariffs by policymakers has only fueled short-end inflation expectations and the call for a high-for-longer Fed, with the market at one point pricing in a 20% chance of a hike in 2025. CIO adjusted our Fed forecast from 100bps of cuts to 50bps of cuts in 2025 in conjunction with the Fed’s updated December SEP projections.
As the Fed has remained on hold over the past two meetings, the market has shifted from fears over inflation and the deficit (supply), which originally pushed 10-year yields up to 4.8%, to concerns over slower growth, as sentiment metrics, such as consumer confidence, continued to slow. Within the confidence sub-indices, the percent of consumers expecting fewer jobs over the next six months rose to the highest level since 2023. While sentiment measures are not necessarily known to be strong economic indicators, nominal yields have been coming down owing to the decline in real yields, signaling slower growth ahead. The volatility in equity markets has also been a tailwind to the recent decline in Treasury yields as a risk-off sentiment takes hold.
Yields rose steeply to start the year, as the Fed kept rates steady, the economy continued to prove resilient, and the new administration was viewed favorably by equity markets. However, with increased policy uncertainty there has been a temporary risk off sentiment which has flattened the yield curve. We take the opportunity to reduce our interest rate risk and take our profits within our fixed income portfolio.
Although we continue to believe in the disinflation trend, and anticipate a slower but solid growth environment, the market is currently pricing in 60bps of cuts in 2025, a large shift from only three weeks ago, as well as an expectation of an announcement of pause in QT at the March Fed meeting. As a result, short covering from the investment community has pushed yields to our short-term objective.
We remain long the belly (five-to seven-year) area of the curve and look for rates to trend lower as the Fed begins to cut in the second half of the year.
Original report - Time to trim the belly, 26 February 2025.
