Employment data supports confidence in rate cuts, with giants like Pimco betting that short-term bonds will continue to outperform long-term bonds through 2026.

Bond investors seem to still have room for further profit on the overall bet on the Federal Reserve's policy path in 2026 and the Treasury market. The closely watched employment report released last Friday showed that the number of new jobs added last month was lower than market expectations, which fully supported the market's expectations for further interest rate cuts by the Federal Reserve to support the economy; at the same time, this result further bolstered the market's 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 "steepening trade," was the hottest investment strategy in the bond market for most of 2025, with fixed-income giants like Pimco entering the scene. This strategy continues to be effective in 2026 - the yield spread between 2-year and 10-year U.S. Treasury bonds widened to the highest level in nearly nine months last week. "We are long-term investors, and in the next 12 to 24 months, there are many scenarios that will yield fruitful results for the steepening trade," said Pramod Athreya, Fixed Income Portfolio Manager at Capital Group. The employment report also marked the end of a series of major events for the strategy. Last Friday, traders were also wary of the Supreme Court possibly ruling on a challenge to President Trump's tariffs order; however, the court did not issue any opinion. But if the court ultimately rules against Trump, given that tariffs can generate revenue for the government, Treasury bonds may come under pressure. Investors also digested Trump's call for Fannie Mae (FNMA.US) and Freddie Mac (FMCC.US) to purchase $200 billion in mortgage-backed bonds. Inflation Hurdles The data focus now turns to the Consumer Price Index for December, which will be released on Tuesday. The market expects this report to show that inflation remains high, providing a basis for the Federal Reserve to "stand pat." Since September last year, the Federal Reserve has cut interest rates three times, with traders expecting the next rate cut to come in mid-2026, followed by another cut in the fourth quarter; changes in expectations for this timing will continue to impact the bet on the "wider yield curve." Sumbadra Rajappa, Head of Rates Strategy at Natixis, believes that the momentum of this trade is waning. "I don't see how much further the curve can steepen, stable labor market and sticky inflation mean fewer rate cuts," she said. It is noteworthy that the report last Friday also showed a decline in the unemployment rate in December, dispelling any discussions of a rate cut this month, causing the curve bet to unwind, with the 2-year and 10-year yield spread narrowing to the smallest since the end of last year. However, overall, this is still the preference of US bond managers. Analysis by J.P. Morgan of the top 25 largest active core bond funds shows that the historical exposure of these funds to this position is still high, despite a slight convergence since the end of last year. Timing is Key Timing is crucial, according to Brian Quigley, Senior Portfolio Manager at Vanguard. "We have a neutral stance on rates; the only trade we've liked since the beginning of the year is a steeper curve." At the beginning of the year, this asset manager expected, in the face of surging bond supply, global investors would demand higher premiums from longer maturities; this week will see a total of $61 billion in 10-year and 30-year Treasury auctions, which could put pressure on these maturities. Athreya from Capital Group is positioning for a steeper curve by being overweight on the short end - he believes that once there is a widespread "flight to safety" in credit or equities, triggering bets by traders on a larger rate cut by the Federal Reserve, this structure will pay off; signs of economic growth pushing long-end yields higher, or concerns about the deficit heating up, will also be favorable. Tatiana Darie, Macro Strategist at Bloomberg, said that the employment trend looks like the economy is slipping into a recession, which explains why traders are still betting on further easing by the Federal Reserve, despite hopes for a rate cut in January being dashed. In conclusion, these contradictory signals leave bond traders with almost no clue about the yield path, especially with supply risks and high December CPI still hanging over their heads. As they await the final announcement from the Supreme Court on the tariff ruling, traders will also be worried about government spending issues. The Court has announced Wednesday as its next opinion release date. Some traders believe that if the ruling is against imposing tariffs, the narrative behind it will be more complicated - in addition to exacerbating concerns about deficit expansion and thereby increasing the size of the national debt auctions, John Brady Corporation Class A, Managing Director at RJ OBrien, pointed out that a smaller tariff list would initially weaken the concern of "tariffs driving up inflation", a view that could support the long end, thereby breaking the bet on the yield curve continuing to widen. However, even this perspective has a downside: after all, Federal Reserve Chairman Jerome Powell's term ends in May, and investors are closely watching the prospect of Trump nominating a successor who is more inclined to quickly cut interest rates, especially when there are signs of cooling inflation. "If that happens, the market will likely price in expectations for the third rate cut of the year in advance," said Tony Rodriguez, Head of Fixed Income Strategy at NewEdge Investments.