Bond investors still appear to have room for further gains on their overall bets regarding the Federal Reserve's policy path and the Treasury market in 2026. The closely-watched employment report released last Friday showed that job additions for the previous month fell short of market expectations, robustly supporting the market's anticipation of further Fed rate cuts to bolster the economy; simultaneously, this outcome has further solidified confidence in the bet that "short-term bonds will outperform long-term bonds this year," driving the yield spread between the two maturities to continue widening. This strategy, known as the "steepening trade," was one of the hottest investment strategies in the bond world for much of 2025, with fixed-income giants like Pimco joining the fray. The strategy has remained notably effective heading into 2026—last week, the yield spread between 2-year and 10-year U.S. Treasuries widened to its largest level in nearly nine months.
"We are long-term investors, and there are many scenarios over the next 12 to 24 months where the steepening trade could be very profitable," said Pramod Atluri, a fixed-income portfolio manager at Capital Group. This employment report also brought a conclusion to a series of major events for the strategy. Last Friday, traders were also alert to the possibility of a Supreme Court ruling on challenges to former President Trump's tariff orders; however, the court issued no opinion. But if the court ultimately rules against Trump, considering that tariffs generate fiscal revenue, Treasury bonds could face pressure as a result.
Investors also digested Trump's call for Fannie Mae (FNMA.US) and Freddie Mac (FMCC.US) to purchase $200 billion worth of mortgage bonds. The focus on inflation hurdles now shifts to the Consumer Price Index (CPI) data for December, due on Tuesday. The market expects this report to show that inflation remains elevated, providing justification for the Fed to "stay put." Since last September, the Fed has cut rates three times; traders anticipate the next rate cut will occur around mid-2026, followed by another in the fourth quarter. Shifts in expectations regarding this timing will continue to impact the "yield curve widening" bet.
Subadra Rajappa, head of U.S. rates strategy at Société Générale, believes the momentum for this trade is waning. "I don't see much more room for the curve to steepen further; a stable labor market and sticky inflation imply fewer rate cuts," she stated. Notably, last Friday's report also showed a decline in the December unemployment rate, which completely quashed discussions of a rate cut this month. Consequently, curve bets were pared back, with the 2-year to 10-year yield spread narrowing to its smallest level since the start of the year.
Nevertheless, overall, this remains a favored position among U.S. bond managers. An analysis by J.P. Morgan of the 25 largest active core bond funds shows that their historical exposure to this position remains elevatedyat, although it has moderated slightly since the end of last year.
Timing is the critical issue, according to Brian Quigley, a senior portfolio manager at Vanguard. "We are neutral on rates; the only trade we've favored since the start of the year is curve steepening." At the beginning of the year, this asset manager anticipated that global investors would demand a higher premium for longer durations in the face of heavy bond supply; this week's auctions totaling $61 billion in 10-year and 30-year Treasuries could put pressure on these maturities.
Capital Group's Atluri is positioning for a steeper curve by overweighting the short end—he believes this structure would work if broad-based "risk-off" sentiment emerges in credit or equity markets, prompting traders to bet on more aggressive Fed easing. It would also be beneficial if signs of economic growth push long-end yields higher, or if concerns about the deficit intensify.
Tatiana Darie, a macro strategist at Bloomberg, noted that the employment trend is behaving as if the economy is sliding towards a recession, which explains why traders continue to bet on further Fed easing, even though hopes for a January cut have been dashed. In summary, these conflicting signals are creating a tug-of-war, leaving bond traders with little clear direction on the yield path, especially with supply risks and December's CPI data still looming overhead.
While awaiting the Supreme Court's final announcement on the tariff ruling, traders will also have government spending issues on their minds. The court has designated Wednesday as its next opinion release day. Some traders believe that a ruling against the tariffs would present a more complex narrative—beyond exacerbating concerns about a swelling deficit and potentially larger Treasury auction sizes, John Brady, managing director at RJ O’Brien, pointed out that a smaller tariff list would, from the outset, weaken fears that "tariffs push inflation higher." This interpretation could support the long end of the curve, thereby breaking the "yield curve continuing to widen" bet.
However, even this perspective has a counterpoint: after all, Fed Chair Jerome Powell's term ends in May, and investors are closely watching the prospect that Trump might nominate a successor more inclined to cut rates quickly, particularly if signs of cooling inflation emerge. "If that happens, the market would likely start pricing in expectations for a third rate cut this year well in advance," said Tony Rodriguez, head of fixed-income strategy at Newfleet Asset Management.
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