Analysis-Some investors tiptoe back into Treasuries, as hawkish Fed clouds outlook

By Davide Barbuscia

NEW YORK (Reuters) - Expectations that a hawkish Federal Reserve will cause an economic slowdown are pushing some investors to increase exposure to long-term Treasuries, as policymakers continue signaling they are ready to ramp up their fight against inflation.

Betting on upside in Treasuries has been a risky proposition this year. Interest rates, which move inversely to Treasury prices, have galloped higher in 2022 as the central bank has grown progressively more hawkish, dealing the U.S. government bond market its worst start to the year in history and gouging investors betting the selloff would abate.

Nascent Treasury bulls, however, believe that the meatier rate hikes and speedy balance sheet tightening the central bank has signaled will eventually slow U.S. growth expectations and prevent Treasury yields from going much higher.

“We have been incrementally adding longer-duration bonds into our portfolios in anticipation of market participants pricing in slower growth moving forward,” said Gavin Stephens, director of portfolio management at Goelzer Investment Management.

The Fed’s hawkish stance was underlined on Thursday when Fed Chairman Jerome Powell said a half-point interest rate increase "will be on the table" at the central bank’s monetary policy meeting next month. Investors are pricing in over 240 basis points of tightening for the rest of this year. [FEDWATCH]

Some economists have warned the Fed’s actions could make recession more likely by potentially pressuring spending or precipitating drops in stocks and other assets, hurting household wealth.

Stephens began adding longer-duration bonds weeks ago, after rates on two-year Treasuries briefly exceeded those on 10-year Treasuries. The phenomenon, known as an inverted yield curve, is viewed as a signal of economic worries and has preceded past recessions.

Ten-year Treasury yields have historically moved lower after an inversion of the 2s/10s yield curve, he said.

At the same time, net bets against U.S. Treasuries have recently hit their lowest level since the end of 2021, a JPMorgan survey showed earlier this month.

"The Fed's focus is fully on inflation ... (it) is prepared to inflict real economic pain on the economy to achieve inflation goals," said Dean Smith, chief strategist at investment firm FolioBeyond.

BofA Securities said earlier this week that yields on 10-year notes offered an attractive entry point for buyers, expecting inflation to ease from recent multi-decade highs.

"While CPI (consumer price index) inflation is 8.5%, we believe the market may be overemphasizing inflation risks,” BofA strategists said in a note on Wednesday.

Not surprisingly, plenty of investors are wary of betting on a reversal in Treasuries after yields on the 10-year have climbed by 140 basis points this year back to levels last seen in 2018.

Ryan O'Malley, a fixed income portfolio manager at Sage Advisory, recently lightened his underweight position on Treasuries, due to expectations of lower inflation and what he believes are early signs of slowing growth, such as recent declines in home sales and homebuilder sentiment.

Still, he believes yields can rise further, especially as the central bank plans to trim its nearly $9 trillion balance sheet at a projected maximum pace of $95 billion per month, an operation policymakers said they could initiate as soon as next month.

"If the Fed starts to roll off nearly $100 billion a month and buyers don't show up in large numbers to pick up the slack ... prices are going to go down and yields higher," he said. "It's just the mechanics of the market."

(Reporting by Davide Barbuscia; Editing by Ira Iosebashvili and Cynthia Osterman)

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