Explainer: Short-Dated Debt Becoming More Attratctive On Wall Street

The Treasury market is focusing on short-term debt with a 4%-plus yield as the Fed gears up to lower rates and support a soft landing. This sentiment is driven by the belief that the economy may avoid a recession and investors’ lack of appetite for longer-term securities. The two-year Treasury is the sweet spot on the yield curve, offering an attractive yield of around 4.4%.

The Fed revealed most of their 2024, 2025’s rate outlook, so rates are going lower. Investors now tend to favor a mixture of two-year and five-year bonds as out the curve is not where most analysts see much value. Long-term debt is poised to underperform, as traders want to be compensated for the added risk they see embedded in these securities.

The two-year note appeals from a look at the yield curve, which first inverted this cycle over a year-and-a-half ago, resulting in long-term rates trading below those on debt with shorter tenors. A groundswell of investors is wagering it will flip back to a more usual pattern sometime next year. At present, the 10-year note yield is about 50 basis points below that on debt with two years to maturity.

US 10-year yields will fall toward the low 3%-range next year as a positive slope could surface by the end of 2024. Fed policymakers penciled in no further interest-rate hikes and left the target range at between 5.25% to 5.5%. Officials’ quarterly projections showed 75 basis points in cuts next year, with the federal funds rate dropping to 3.6% by the end of 2025 and then declining to 2.9% a year later.

Skilled investors now prefer to bypass 2 years and buy 5-years and further out, because there is some risk around whether the Fed will stick a soft landing. The sudden shift in the bond market has highlighted the sense that 5% Treasury yields were too good to pass up, extending a rally for many fixed income funds that not so long ago were expecting another poor performance this year.