Bond investors' flagship steepener trade strategy received strong validation from December's weaker-than-expected US employment report, reinforcing market expectations for additional Federal Reserve interest rate cuts throughout the year. The employment data showed job growth below forecasts, supporting confidence in the strategy that has attracted major fixed-income players including Pimco and Capital Group.

Steepener Trade Momentum Builds

The steepener trade, which involves betting that short-maturity Treasuries will outperform their longer-term counterparts, has emerged as one of the most popular bond strategies. This positioning capitalizes on the expectation that the Federal Reserve will continue cutting rates, causing short-term yields to fall more dramatically than long-term rates.

"We're longer-term investors, and over the next 12 to 24 months there's a lot of scenarios where a steepener is going to work out well," said Pramod Atluri, a fixed-income portfolio manager at Capital Group. The strategy has shown particular strength as traders position for continued Fed easing to support economic growth.

Mixed Employment Signals Create Complexity

While December job growth disappointed expectations, the employment report also revealed a decline in the jobless rate, creating conflicting signals for monetary policy. This mixed data caused some unwinding of steepener positions, with the difference between 2-year and 10-year yields shrinking to its smallest gap since year-end.

Subadra Rajappa, head of US rates strategy at Societe Generale, expressed caution about the trade's future momentum. "I don't see much room for the curve to continue to steepen," she noted. "A stable labor market and sticky inflation argue for fewer cuts."

Key Market Catalysts Ahead

Several critical events could reshape the steepener trade outlook in coming days. Tuesday's December consumer price index release is projected to show elevated inflation, potentially supporting the Federal Reserve's case for pausing rate cuts. Additionally, markets remain on alert for a Supreme Court ruling on challenges to Trump's tariffs, which could significantly impact Treasury dynamics.

John Brady, managing director at RJ O'Brien, highlighted the complexity surrounding potential tariff rulings. A decision against the levies could initially reduce inflation concerns, supporting longer maturities and potentially undermining steepener bets. However, the prospect of a new Fed Chair when Jerome Powell's term ends in May adds another layer of uncertainty.

Institutional Positioning Remains Strong

Despite recent volatility, institutional support for the steepener trade remains robust. JPMorgan Chase analysis of the 25 largest active core bond funds shows exposure to the position remains large from a historical perspective, although managers have reduced some exposure since late last year.

Brian Quigley, senior portfolio manager at Vanguard, emphasized the timing considerations. "We are pretty neutral on rates, and the only trade we have liked entering the year is a curve-steepener," he said. The strategy benefits from multiple scenarios, including risk-off moves in credit or equity markets, signs of healthy economic growth, or mounting deficit concerns that could drive long-term yields higher.

Two-year Treasury yields climbed on Friday after December employment data presented a mixed picture that reinforced expectations the Federal Reserve will maintain current interest rates at its upcoming January meeting. The yield-sensitive securities rose as investors recalibrated their rate cut expectations following the jobs report.

December Employment Data Shows Mixed Signals

The December jobs report revealed contrasting trends in the labor market. Employers added 50,000 jobs during the month, falling short of the 60,000 new positions economists had forecast. However, the unemployment rate declined to 4.4%, beating expectations of 4.5%.

Jonathan Cohn, head of U.S. rates desk strategy at Nomura, characterized the report as "decent" and noted it suggested "neither re-acceleration nor material slowing." He attributed part of the unemployment rate decline to the impact of government shutdown effects and furloughed employee reporting.

Fed Rate Cut Expectations Diminish

The employment data significantly reduced market expectations for immediate Fed action. Fed funds futures traders now price in only a 4.8% chance of a rate cut at the Federal Reserve's January 27-28 meeting, down from 11.6% before the data release. Market participants do not expect the next rate cut before April at the earliest.

The Federal Reserve cut rates last month but signaled borrowing costs are unlikely to drop further in the near term as policymakers await clarity on labor market direction, inflation trends, and economic momentum.

Treasury Yield Movements and Market Response

The two-year Treasury note yield, which typically moves in alignment with Fed rate expectations, rose 4.6 basis points to 3.534% and reached 3.543%, the highest level since December 23. The benchmark 10-year note yield fell 1.4 basis points to 4.183%, briefly touching 4.211%, the highest since September 4.

The yield curve between two- and 10-year notes flattened by approximately 5 basis points to 63 basis points, reflecting the market's adjustment to changing rate expectations.

Fed Officials Express Continued Caution

Federal Reserve officials reinforced their cautious stance on monetary policy. Richmond Fed President Tom Barkin described December job growth as "modest" and noted that firms outside healthcare and artificial intelligence-related industries remain reluctant to hire.

Atlanta Fed President Raphael Bostic emphasized that inflation issues remain at the forefront of his economic concerns, describing the job market as being in a "low-hire, no-fire mode" amid broader uncertainties.

Housing Market Developments

Bonds rallied briefly after President Trump announced plans to order representatives to buy $200 billion in mortgage bonds to reduce housing costs. Federal Housing Finance Agency Director Bill Pulte confirmed that Fannie Mae and Freddie Mac will execute the purchases.

Thirty-year mortgage rates fell 22 basis points to 5.99% following the announcement, according to Jefferies analyst Matthew Hurwit, though he noted consensus expectations already anticipated a decline toward 5.9% by year-end.