STOCKS | Investors Bet on Short-Term U.S. Treasuries as Fed Inflation Fight Gains Credibility

U.S. Treasury investors are shifting toward short-term bonds, betting that the Federal Reserve will ultimately win its fight against inflation. According to Sina Finance, two-year Treasury yields jumped to about 4.75% in the days after the Fed's first rate hike since 2023, while futures markets priced in another 80 basis points of tightening over the next year. Bullish investors said the beaten-down price of two-year Treasuries already reflects those expectations, and that bond prices could respond if inflation improves or if the Fed hikes less than expected. Demand was strong for options that would benefit from a decline in the secured overnight financing rate, which is closely tied to policy expectations. WisdomTree investment strategy head Kevin Flanagan said the front end looks most likely to overshoot if any part of the yield curve does. He added that two-year Treasury yields are far above the current fed funds rate, suggesting short-end yields have risen too much. The two-year U.S. Treasury yield, often seen as the bond most sensitive to Fed policy, has risen about 140 basis points from its February low, when markets expected rate cuts rather than hikes. It is now well above the Fed's new 3.75% to 4% federal funds target range, with bond market moves running ahead of the Fed's pace; the Fed is expected to raise rates once more this year and keep policy steady in 2027. Supporters of the trade also pointed to the fact that the maturity is less exposed to sharp price swings while offering its highest yield since 2024. Allspring Global Investments fixed income chief investment strategist George Bory said the message to clients is that now is a good time to add duration in the middle of the yield curve. The firm increased its bond holdings after Jerome Powell's Jackson Hole pledge to restore price stability, and the Fed's latest meeting further strengthened its confidence in that view. Investors are watching Tuesday's $69 billion two-year Treasury auction, followed by Wednesday's $70 billion five-year auction, to gauge demand for short-term bonds. Senior Fed officials speaking this week include John Williams of the New York Fed and Beth Hammack of the Cleveland Fed. Risks remain that could derail the trade. Energy prices could rise further if the wars in the Middle East and Ukraine show no sign of ending, adding to inflation and lifting market expectations for much higher borrowing costs ahead. Stronger-than-expected U.S. economic performance could have a similar effect. Bank of America strategists said investors should prepare for the Fed to potentially raise its benchmark rate above 5%, which would exceed current market expectations. They said Jerome Powell's comment that last week's hike was effectively a reduction in easing suggests officials do not currently believe monetary policy will hinder the U.S. economy.