After a sluggish second quarter, the "hottest U.S. Treasury bond trade" is back

An unexpectedly weak employment report has completely reversed the pessimistic sentiment in the U.S. Treasury market, and the previously battered "steepening yield curve" strategy is making a comeback.

Last Friday, the weak non-farm payroll report for July triggered a rush in the U.S. Treasury market. The report not only showed a slowdown in job growth but also revised the data for May and June downwards by a total of 258,000 people. Kevin Flanagan, head of fixed income strategy at WisdomTree, stated:

What we are seeing now is a completely different labor market backdrop, and nothing changes the market narrative more than a downward revision of 250,000.

Subsequently, yields on U.S. Treasuries across all maturities fell, with the two-year Treasury, which is sensitive to interest rates, leading the decline, dropping more than 25 basis points in a single day, marking the largest single-day drop since December 2023. This led to an expansion of the yield spread between short-term and long-term bonds, providing substantial returns for investors betting on the so-called steepening trend.

At the same time, traders are betting that the Federal Reserve will cut interest rates sooner, with futures market prices indicating that the likelihood of a rate cut next month has soared to 84%, and the market expects at least two rate cuts by the end of the year.

Reversal of "Pain Trade"

The steepening yield curve, which bets on the widening difference between short-term and long-term Treasury yields, had been quiet since April this year and had caused losses for investors for most of July, long regarded as a "pain trade."

Due to the high financing costs of maintaining this position, many were forced to close their positions. Uncertain economic data and the unpredictability of tariff policies left the market lacking catalysts.

However, for those investors who held on, last Friday was undoubtedly a day of "waiting for the clouds to part and the moon to shine." As short-term yields plummeted, the yield difference between the two-year and thirty-year Treasuries recorded the largest single-day increase since April 10. Mark Dowding, Chief Investment Officer of BlueBay Fixed Income under RBC Global Asset Management, stated: "We remain optimistic about the steepening outlook, so we are pleased to see such price movements."

Data shows that the futures trading volume in the early session last Friday reached about three times the usual level, indicating that investors are eager to rebuild this strategy position in hopes of profiting during the Federal Reserve's rate-cutting cycle.

Increased Expectations for Early Rate Cuts

This weak employment report provides strong evidence for those advocating that the Federal Reserve should cut rates early, including dissenting Federal Reserve governors Waller and Bowman, as well as U.S. President Trump, who has repeatedly pressured Powell Tony Farren, Managing Director of Mischler Financial Group, pointed out that Powell's speech on Wednesday "essentially ruled out the possibility of a rate cut in September, opening the green light for shorting short-term bonds," but weak employment data forced investors to quickly cover short positions.

However, challenges still lurk behind the market's exuberance. For bond bulls, they need to assess whether the deterioration in the labor market signals broader economic weakness, which could offset inflation risks that may arise from tariffs in the coming months.

Priya Misra, Portfolio Manager at JPMorgan Investment Management, stated that the July employment report "significantly increased the probability of a rate cut in September, but it's not a done deal yet, as the unemployment rate remains low and we still face upward inflation risks due to higher effective tariff rates."

John Canavan, an analyst at Oxford Economics, noted that next week's $125 billion Treasury issuance could help support the steepening trend, as the government will issue securities including $10 billion and $30 billion 10-year and 30-year bonds