By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) -Bond investors are re-examining their holdings of longer-dated Treasuries, with some reducing positions and others even going short relative to their benchmark, as the Federal Reserve prepares to cut interest rates by another quarter percentage point on Wednesday.
Many bond investors expect the Fed to continue to adopt a measured pace in cutting interest rates. Portfolio managers tend to favor duration, which entails buying longer-dated debt, when the Fed is easing, as a hedge against further economic weakness. But some investors are backing away from that trade on views a soft landing for the world’s largest economy remains within reach.
The Federal Open Market Committee, which sets monetary policy, is expected to end its two-day meeting by announcing it will lower the benchmark overnight rate by 25 basis points to a range of 3.75%–4.00%, which would be its second easing this year. In September, the FOMC ended a nine-month pause, cutting rates by a quarter of a point as signs of a weakening labor market emerged.
Investors will also closely parse remarks from Fed Chair Jerome Powell for signals about when the central bank might conclude its balance sheet reduction program, known as quantitative tightening (QT).
Powell recently signaled that the end of QT is approaching — fueling speculation that the Fed could either announce its conclusion at this week’s meeting or outline a roadmap for winding it down.
This should be bullish for Treasuries because it reduces their supply in the market, pushing prices higher and yields lower. An exit from QT also means the Treasury’s financing requirements would decline because it no longer needs to borrow as much to cover the Fed’s redemptions.
Under QT, Treasury’s borrowings effectively increase. The Fed shrinks its balance sheet by letting the bonds it holds mature. The Treasury redeems the debt and pays the U.S. central bank by subtracting the required amount from the cash balance it keeps on deposit at the Fed. In order to replace the cash it paid the Fed, the Treasury needs to sell new securities.
“It’s another tailwind for fixed income such as Treasuries,” said Neil Sutherland, portfolio manager at Schroders.
“At the margin, it merits going long bonds but since yields have come down, valuations are not quite as compelling as they were three to four months ago. It does suggest that fixed income remains well supported.”
PULLBACK FROM DURATION?
When the Fed enters a rate-cutting cycle, investors typically extend duration, anywhere from U.S. five-year to 30-year Treasuries. In periods of easing, shorter-dated yields fall, so investors reach further out the curve to lock in higher long-term rates before they decline further.
As such, longer-dated debt has historically outperformed shorter-duration Treasuries during Fed easing.
“Dealers are telling me that I should extend duration and buy as long as I possibly can because we’re going into recession and everything’s going to break down,” said Byron Anderson, head of fixed income at Laffer Tengler Investments in Scottsdale, Arizona.
“But I’m just on the other side of that argument, pushing short, being protective, buying T-bills, and just waiting. I’m not buying the idea that we’re going into economic disaster. I know things are bad for big parts of the consumer base and I get that the job market has stagnated, but it hasn’t fallen off a cliff.”
Overall, there has been a retreat from long-duration positioning.
JP Morgan’s latest Treasury Client Survey showed that the percentage of investors that are long duration relative to their benchmark fell as of October 20, while those with shorter duration increased. The survey of all its clients showed the fewest outright longs since August 25, the bank said.
Brendan Murphy, head of fixed income, North America at Insight Investment in Boston, said the firm is still overweight duration overall, “but probably a bit less overweight than we were earlier in the year.”
He added that “rates have rallied a fair amount and so we’ve reduced duration a little bit.” That overweight, he added, is concentrated in the “intermediate part of the curve and probably the five-year is where the preference is.”
Tony Rodriguez, global head of fixed income strategy at Nuveen in Minneapolis, believes in going slightly above neutral duration in bond portfolios, or adding a little bit more risk with the focus as well on the front and intermediate sector.
The positioning reflects steady fundamentals and a solid technical picture in the bond market, Rodriguez said.
“We think the economy will do a little better next year than this year,” the Nuveen strategist said. “You will begin to see a little progress on inflation. It’s going to be slow, but that will cause the Fed to be less aggressive with cuts.”
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Andrea Ricci )
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