Short-End Treasuries Become Popular Bet on Fed Inflation Win

Investors in the US Treasury market are shifting their focus to owning shorter-dated government bonds, a bet that the Federal Reserve will eventually emerge victorious in its fight against inflation.

Two-year yields have soared to a multi-year high of around 4.75% in the days following the Fed’s first rate increase since 2023, the latest leg of a selloff in the underlying bonds. Futures are pricing in another 80 basis points of monetary policy tightening in the coming year, evidence that Chairman Kevin Warsh’s vow to go all out in the battle against inflation is gaining credibility with traders.

Bullish investors are confident that the battered two-year’s price already reflects those increases and could roar back if inflation improves or the Fed raises rates less than expected. Such bets were already proliferating a day after the Fed meeting, with demand surging for options that would benefit from a decline in the Secured Overnight Financing Rate, which is closely tied to policy expectations.

“If you were to look at any part of the curve right now and ask where is there a potential overshoot in yields, it looks like the front-end,” said Kevin Flanagan, head of investment strategy at WisdomTree. “The two-year is trading well above the current Fed funds rate and that suggests the front-end has moved too far ahead.”

Yields on two-year Treasuries — typically seen as the most sensitive to Fed policy — have already risen by around 140 basis points from their February lows, when the market was positioned for cuts, rather than hikes. At around 4.72%, they now stand far above the new Fed rate setting of 3.75% - 4%, with the bond market running well ahead of central bank officials, who expect one more increase this year followed by a steady policy setting for 2027.

Proponents of the trade also note the tenor is less subject to the violent price swings that can grip the longer end of the curve while offering holders its richest yield since 2024.

“Our message to our clients is that now is a good time to add duration out into the intermediate part of the curve,” said George Bory, chief investment strategist of fixed income at Allspring Global Investments.

The firm boosted its bond holdings following Warsh’s Jackson Hole pledge to restore price stability, with the recent Fed meeting further increasing their conviction in the position, Bory said.

See more: Investing After a Liquidity Event