US Treasury Yield Curve Anomaly: A Closer Look

Interest rate strategists at Goldman Sachs have pointed out an intriguing anomaly in the US Treasury market: the 5-year Treasury bond appears unusually expensive compared to other maturities. With the exception of the period when the Federal Reserve lowered its overnight lending rate target floor to 0%, the current situation is quite rare.

The Current Landscape: Overvalued 5-Year Treasuries

The 5-year US Treasury yield currently hovers around 3.78%, a high within the range it has occupied since the beginning of 2022. However, when these bonds are assessed using a common relative value method (comparing their yield to shorter- and longer-term yields), they appear historically overvalued.

Goldman Sachs Analysis: The 'belly' is Expensive

In an August 5 report, strategists William Marshall and Bill Zu highlighted this phenomenon, noting that the "belly" (the 5-year Treasury) is overvalued and represents a key feature of the current US Treasury market. They reached this conclusion by comparing the 5-year Treasury yield to the yields of 2-year and 30-year bonds.

'Butterfly Spread' Strategy: Signaling Overvaluation

This comparison relies on a strategy known as a 'butterfly spread'. This involves doubling the 5-year Treasury yield and then subtracting the sum of the 2-year and 30-year Treasury yields. The result is approaching -100 basis points, a low in the range since the beginning of 2021, strongly suggesting the 5-year is overvalued.

Rate Cut Expectations: The Primary Driver

Marshall and Zu attribute this valuation primarily to market expectations regarding the timing and magnitude of interest rate cuts by the Federal Reserve. "Since the start of this year, the market has priced in more near-term cuts, as well as cumulatively larger cuts," they wrote. However, they believe this state may not persist.

5-Year Treasury Performance: Fueled by Easing Expectations

Fueled by these expectations, the 5-year Treasury has been the best-performing segment of the US Treasury market this year. However, persistent inflation and US budget deficit trends are putting upward pressure on longer-term bond yields. The Goldman Sachs strategists suggest this may also reflect market expectations that the “policy path could be easier after the middle of next year,” following an anticipated leadership change at the Fed.

Potential Policy Impact: Are Investors Betting on Trump?

Trump has repeatedly called for Fed Chair Powell to cut interest rates, even demanding significant reductions down to 1%. While the Fed has not yet responded, these signs in the Treasury market could suggest that investors are to some extent betting on the prospect of the Fed sharply cutting rates during a potential second Trump term.

Yield Movement: An Overview

Since the end of last December, the 5-year Treasury yield has fallen by 60 basis points, the 2-year yield has fallen by 52 basis points, while the 30-year yield has remained largely unchanged.