By Gertrude Chavez-Dreyfuss
NEW YORK, Dec 8 (Reuters) – Bond investors are positioning for a shallow easing cycle from the Federal Reserve as it gears up for its final policy meeting of 2025, reducing exposure to long-duration Treasuries and rotating into intermediate maturities for juicier returns.
Many Wall Street banks have penciled in fewer Fed interest rate cuts in 2026 on lingering inflation concerns and expectations of a more resilient U.S. economy.
Against that backdrop, the shift to the so-called belly of the curve – such as U.S. five-year Treasuries – reflects a view that the typical strategy of loading up on long bonds during rate-cutting cycles may not deliver the same payoff this time. The thinking hinges on inflation and the Fed’s evolving policy stance.
The U.S. central bank’s policy-setting Federal Open Market Committee is widely anticipated to lower its benchmark overnight rate by 25 basis points to the 3.50%-3.75% target range at the end of a two-day policy meeting that starts on Tuesday.
Investors will also scrutinize the FOMC statement as well as Fed Chair Jerome Powell’s post-meeting remarks for signals that the benchmark rate is close to neutral, the level at which monetary policy is neither accommodative nor restrictive, potentially near 3%.
The Fed has reduced rates by a quarter of a percentage point at each of its September and October meetings after a nine-month pause.
“We are expecting a shallow path of rate cuts, mainly because inflation is still too high and … that’s a concern for a lot of voting (FOMC) members especially for some rotating in next year,” said Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research.
But the labor market is cooling, although not falling off a cliff, Martin said.
Barclays sees the Fed delivering two more 25-bp rate cuts, in March and June, while Deutsche Bank sees the Fed on hold in early 2026, but easing again in September under a new and more dovish leadership.
HSBC, on the other hand, said the central bank will pause over the next two years after a rate reduction on Wednesday.
When the Fed enters a rate-cutting cycle, investors typically extend bond duration, anywhere from 10-year to 30-year U.S. 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 traditionally outperformed shorter-duration Treasuries when the Fed is cutting rates.
With the inflation rate remaining above the Fed’s 2% target, bond investors anticipate a higher neutral rate of possibly 3%. A structurally higher neutral rate creates a floor for yields, analysts said, particularly 10-year Treasuries.
If the neutral rate is higher, the upside for long-duration bonds could be capped, making intermediate maturities or the belly of the curve a more attractive hedge against policy uncertainty and inflation persistence, analysts said.
DISINFLATION HAS STALLED
“We prefer remaining in the belly across the curve. Because of what’s being priced in, the markets being positioned on the front end incurs very steep carry costs,” said Dhiraj Narula, U.S. rates strategist at HSBC, noting that inflation is being underpriced by the market right now.
When markets expect Fed cuts, being long the front end of the curve incurs high daily costs because the market is priced for yields to fall going forward.
“The inflation being driven by tariffs has not been quite as severe as markets are expecting, but overall disinflation has stalled closer to 3% than the Fed’s 2% target, and that is quite a strong incentive to keep policy at least closer to neutral,” Narula said.
The long end, on the other hand, presents its own problems.
“It’s difficult to have confidence on the long end for a variety of factors such as budget and fiscal concerns,” said Greg Wilensky, head of U.S. fixed income and a portfolio manager at Janus Henderson Investors.
“You also have concerns about Fed independence as well as all the things going on globally. So we prefer to have that duration exposure away from that part of the curve.”
Wilensky added that bond portfolio duration at his firm is five years and higher. “We were more overweight twos (two-year notes) versus fives (five-year notes) before and now it’s more fives and some twos.”
JP Morgan’s latest Treasury Client Survey showed the percentage of investors that are long duration relative to the their benchmark declined by nine percentage points as of December 1. A survey of all clients also showed the fewest net-long positions since November 3.
Investors will also focus on the release on Wednesday of Fed policymakers’ quarterly economic projections, including policy rate forecasts, also known as the “dot plot.”
The “dots” from the September meeting, when the Fed resumed its easing cycle with a 25-bp cut, showed a policy rate of 3.6% by the end of this year, 3.4% at the end of 2026, and 3.1% by the conclusion of 2027.
Janus Henderson’s Wilensky thinks the Fed will stick to the 3.4% policy rate next year in the dot plot, higher than the 3% being priced by the market.
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Paul Simao)
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