Bond giants flock to "curve belly": Betting on 5-year US Treasury Bonds to become the "sweet spot" of the Powell era trading.

Against the backdrop of Federal Reserve Chairman Kevin Warsh ushering in a new era of hawkishness, some of the world's largest bond management companies are focusing on the "belly" of the U.S. Treasury yield curve - the five-year maturity, believing it to be the best position to navigate the current policy uncertainty. From Capital Group to Insight Investment, from Natixis to The Pacific Investment Management Company (PIMCO), the message is highly consistent: the "belly" of the yield curve - the five-year maturity - is the best position to navigate the early days of the Warsh era. As Warsh's hawkish comments at the June FOMC meeting led to stabilization in U.S. bond yields, coupled with a decline in oil prices and traders cutting back on aggressive rate hike bets, these giants are accelerating their focus on mid-term government bonds. As of last Friday (June 26th), the yield on the five-year U.S. Treasury bond was 4.13%. This is a number that combines both yield and defense - high enough to provide a decent interest income, yet "middle" enough to avoid extreme risks at both ends. Why has the "belly" strategy become a consensus? The triple logic of the "sweet spot" Crossing cycles: able to accommodate rate hikes and rate cuts The favoritism for the five-year U.S. Treasury bond in the current environment stems from its unique risk-return characteristics - it is at the intersection of Federal Reserve policy rate expectations and long-term inflation expectations, neither as overly sensitive to short-term rate changes as the two-year maturity, nor as susceptible to large inflation and term premium risks as the thirty-year maturity. Brendan Murphy, head of North American fixed income at Insight Investment, bluntly stated: "The five-year maturity is a good balance point" and "a good inflection point." The global asset management company with assets under management of approximately $836 billion believes that mid-term government bonds can lock in decent yields while avoiding excessive interest rate volatility. Chitrang Purani, portfolio manager at Capital Group, provided a more detailed explanation: "The front-end of the yield curve is more volatile, so I prefer mid-term rates." He pointed out, "The inflation trajectory and economic growth resilience so far this year do support rate hikes, but looking ahead, the drivers of economic growth are still unbalanced, and inflation has not been driven by demand-side factors." Capital Group manages assets of over $3 trillion. Risk-return ratio: avoiding pitfalls at both ends Short end (2-year): highly dependent on the Federal Reserve's policy path, extremely sensitive to every official's speech and economic data. After Warsh scrapped forward guidance, the volatility in this segment sharply increased. Long end (10-year, 30-year): highly sensitive to inflation expectations and term premiums. Warsh's plans to reorganize the Fed's balance sheet and gradually reduce holdings of mortgage-backed securities (MBS) are changing the supply-demand structure of long-term government bonds. Mid term (5-year): not overly exposed to policy noise or inflation risks, making it the "safest" duration exposure. John Briggs, head of U.S. rate strategy at Natixis North America, outlined the advantages of the "belly" from a policy cycle perspective: "If the Fed raises rates in 2026, they'll be out of rate hikes by the latter part of 2027." Therefore, he prefers a "slightly looser market to allow more time to digest potential rate cut expectations." Dan Ivascyn, Chief Investment Officer at PIMCO, made a clearer signal at a media roundtable in mid-June. He pointed out that the most attractive opportunity in the bond market at the moment is the five-year U.S. Treasury bond. "The risk for cash investors is that economic growth may encounter some unforeseen shocks," Ivascyn warned, "You might have originally expected to receive about a 4% cash return over the next five years, but suddenly interest rates drop to 2%, and you can only earn a 2% return for the rest of your time." Extending the investment horizon to five years can allow investors to lock in higher yields for a longer period - the current yield on the five-year U.S. Treasury bond is around 4.2%. PIMCO manages approximately $2.3 trillion in assets, is overweight duration, and holds bonds in the front and middle of the yield curve (i.e., the 2 to 5-year maturity). Relative value: the butterfly spread is at its highest level in over a year Another big appeal of the five-year Treasury bond is its relative cheapness. The so-called "butterfly yield" - a measure of the five-year Treasury bond yield relative to the two-year and 30-year Treasury bond yields - is currently near its highest level in over a year. This means that from a relative value perspective, the five-year Treasury bond is undervalued. By the end of May 2026, the spread between the five-year and 30-year U.S. Treasury bond yields had narrowed to around 81 to 82 basis points, reflecting investors' relatively reduced demand for term premium in the medium-term maturity. Goldman Sachs had previously pointed out that based on the butterfly spread model, the yield of the five-year maturity is at historic highs. Policy background: the hawkish fog of the Warsh era The concentrated emergence of the "belly" strategy in this round is closely related to the policy framework changes after Warsh took office as the Fed chairman. On June 18, the Federal Reserve left the federal funds target range unchanged at 3.50%-3.75%, but the policy signal was noticeably hawkish. The dot plot showed that about half of FOMC members expect at least one rate hike by 2026. Warsh did not submit a dot plot and canceled forward guidance, emphasizing adherence to the 2% inflation target and data priority. The policy statement removed the "accommodative bias" hinting at potential future rate cuts, and the text was significantly streamlined. At the same time, the Federal Reserve significantly raised its inflation forecast - the fourth quarter PCE year-over-year forecast for 2026 was raised by 0.9 percentage points to 3.6%, while the core PCE was raised by 0.6 percentage points to 3.3%. In terms of economic forecasts, the year-over-year growth rate of actual GDP in the fourth quarter of 2026 was revised down by 0.2 percentage points to 2.2%. Under this policy framework, expectations in the market for the Fed's policy path have experienced significant fluctuations. After the June FOMC meeting, expectations for rate hikes in 2026 rose by 17 basis points to 39 basis points, and the two-year U.S. bond yield rose by 12 basis points to 4.19%. However, with the subsequent release of economic data and recalibration of market sentiment, expectations for rate hikes have eased. Huatai analysis pointed out that Warsh has shown determination to reform the Fed, but market reaction to the hawkish signals in the dot plot may have been over-exaggerated. Soochow believes that as we enter the late summer months, the short-term factors supporting the economy are expected to gradually weaken, and the overly priced rate hike expectations in the market are likely to be readjusted. Market data: resilience of the economy coexists with inflation pressures Recent economic data provides a complex backdrop for this strategy. In terms of inflation, the core PCE price index rose year-over-year by 3.4% in May, reaching its highest level since October 2023; overall PCE rose year-over-year by 4.1%, the highest since April 2023. Inflation pressure comes mainly from energy prices - prices for energy-related goods and services rose by 4% month-on-month. However, the core CPI rose by only 0.2% month-over-month in May, below the expected 0.3%, providing some relief to the market. In terms of growth, the final value of U.S. real GDP for the first quarter grew at an annual rate of 2.1%, higher than the 1.6% previously reported. Personal consumption expenditure rose by 0.7% month-over-month in May, higher than the expected 0.6%, showing that consumer spending remains strong. In the job market, non-farm payrolls increased by 172,000 in May, exceeding expectations for the third consecutive month. The June employment report is expected to be released this Thursday, with the market expecting an increase of about 150,000 to 200,000 jobs. Sarah Chen, senior U.S. economist at Oxford Economics, said, "The labor market is clearly building momentum, but that is precisely what the Fed is most concerned about at the moment." It is worth noting that the recent attack on a tanker in the waters near Oman has once again raised concerns in the market about the situation in the Middle East. This geopolitical risk reminds the market that the sustainability of the ceasefire between the U.S. and Iran is still a key variable. "Bellying" strategies of major institutions Market activity in the past week has already shown traders moderating their hawkish stance. They currently expect the Fed to raise rates one to two times before mid next year, as the peak of tightening policy - previously, they had expected a series of rate hikes to begin as early as next month. The attractiveness of the five-year Treasury bond has been further confirmed in recent data. As of June 26, the yield on the 2-year U.S. bond fell to 4.13%, the 5-year bond fell to 4.167%, and the 10-year bond fell to 4.39%. Compared to two weeks ago, the yield on the 2-year bond rose by 14 basis points, while the 30-year bond fell by 7 basis points, continuing the flattening of the yield curve. Pimco: Overweight 2 to 5 years, going against market expectations Pimco, managing $2.3 trillion in assets, is the most steadfast executor of this strategy. Senior portfolio manager Michael Cudzil says Pimco is overweight in duration, holding bonds in the front and middle of the yield curve (i.e., the 2 to 5-year maturity). Cudzil's basic expectations contradict market pricing: "We don't think the Fed will raise rates, because economic growth in the second half of this year is likely to slow, giving the Fed time to keep rates steady." This area has become more attractive after recent selloffs. He further pointed out, "If the market digests rate hike expectations and begins to discuss potential easing policy, then the front and back-end yields are likely to fall below 4% in the second half of the year. Market sentiment changes rapidly, only a few data points can trigger some volatility." Pimco's positioning data confirms this strategy - in many of its funds, 2-year and 5-year Treasury futures occupy core positions. Insight Investment: "Balance point" of $836 billion Brendan Murphy, head of North American fixed income at Insight Investment, refers to the five-year maturity as a "good balance point" and "good inflection point". With assets under management of approximately $836 billion, the weight of this judgment cannot be ignored. Capital Group: Mid-term rates preferred over front-end Chitrang Purani, portfolio manager at Capital Group, stated clearly: "The front-end of the yield curve is more volatile, so I prefer mid-term rates". He pointed out that while the inflation trajectory and economic growth resilience so far this year do support rate hikes, "looking ahead, the drivers of economic growth are still unbalanced, and inflation has not been driven by demand-side factors". Natixis: Leaving room for rate cuts in 2027 John Briggs, head of U.S. rate strategy at Natixis North America, has a more forward-looking strategy. He believes that if the Federal Reserve raises rates in 2026, they will exit rate hikes in 2027. Therefore, he tends to choose a "slightly looser market to allow more time to digest potential rate cut expectations". Outlook: Finding a balance between hawkishness and dovishness Overall, the five-year U.S. Treasury bond is at the intersection of Federal Reserve policy and inflation expectations. Recent price movements reflect market confidence that energy shocks are gradually fading, while also suggesting that inflation can moderate without significantly worsening economic growth. Standard Chartered bank expects the Fed to maintain rates until the end of the year, and is positive on U.S. bond maturities shortening to 3 to 5 years. DBS Bank also believes that after the release of inflation data, market concerns about further rate hikes have eased. PIMCO's Ivascyn expects that overall inflation will remain under control for the next five years, considering the gradual easing of tension in Iran and the deflationary pressure from artificial intelligence. PIMCO is overweight in duration in the 2 to 5 year maturity, Cudzil said: "If the market digests rate hike expectations and begins to discuss potential easing policy, then the front and back-end yields are likely to fall below 4% by the second half of the year. Market sentiment changes rapidly, only a few data points can trigger some volatility." In this current period of uncertainty, the "belly" strategy may be the prudent choice to navigate through the fog. Risk warning: not without headwinds Although the "belly" strategy has gained widespread consensus, risk factors should not be overlooked. Rate hike risk: If upcoming employment and inflation data show prices are not easing, the Fed may start raising rates as early as September. The two-year Treasury bond, which is sensitive to policy, will bear the most pressure, while the five-year, although relatively moderate, is not immune. According to CME Group data, overnight index swaps are currently pricing in a 45% probability of a 25 basis point rate hike in September. Geopolitical risk: The recent attack on tankers in the waters near Oman serves as a reminder that the back and forth in the Middle East could strike at any time, impacting energy prices and inflation expectations. Economic downturn risk: If rate hike expectations continue to rise, it could lead to tightening financial conditions, suppressing economic growth. Ivascyn of PIMCO noted that in the event of an economic shock and rate declines, investors in five-year U.S. bonds would benefit from price increases - but this also means that the "belly" strategy also holds value for hedging against economic downturn risks.