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Analysis-US bond bulls lean into latest selloff despite inflation scare

FILE PHOTO: Traders reacts to Fed rate announcement on the floor of the NYSE in New York

By Saeed Azhar and Davide Barbuscia

NEW YORK (Reuters) - A sharp selloff in U.S. bonds so far in April is prompting some investors to consider allocating more funds to the asset class to lock in higher yields ahead of interest rate cuts by the Federal Reserve, a prospect that remains investors’ base case despite U.S. economic resilience.

Treasury yields, which move inversely to prices, have soared in recent weeks after a string of solid economic data and three consecutive monthly inflation prints showing a rebound in price pressures pushed out expectations of when the Fed would start cutting rates. The benchmark 10-year yield has approached 5% - a level last touched in October for the first time in 16 years.

But for many, lower bond prices are an opportunity to increase so-called duration - or the interest rate sensitivity of a bond portfolio - because the U.S. central bank has signaled the next likely move in interest rates will be lower. Fund managers increase duration by buying bonds across the curve that benefit most from an interest rate move. When interest rates decline the value of bonds increases.

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"We're still in the scenario in which we have strong economic growth and a Fed that has a bias to ease. That's a pretty benign climate," said Ashok Varadhan, co-head of global banking and markets at Goldman Sachs. He expects investors to rotate from cash to high-yielding fixed income products such as mortgages, credit and emerging markets.

Jim DeMare, president of global markets for Bank of America, said investors are seeing relative value in mortgage and securitized products, even though he cautioned about uncertainty in markets.

Greg Wilensky, head of U.S. fixed income and portfolio manager at Janus Henderson Investors, has been buying corporate and securitized bonds particularly in the short-to-intermediate part of the curve. "After meaningfully reducing duration after the strong rally in the fourth quarter (of 2023), we began adding duration back as yields rose," he said.

Bonds rallied late last year, when inflation was cooling and the Federal Reserve signaled it had likely reached a peak in its interest rate hikes, emboldening bond bulls who had already loaded up on fixed income as yields rose.

Since then, however, things have not played out as expected: inflation is sticky, and Fed officials have repeatedly signaled there is no urgency for a less restrictive monetary policy. Some are even open to hiking again if inflation rebounds.

Year-to-date returns on Treasuries have been negative at minus 3.8%, according to the ICE BofA 7-10 year Treasury Index. Even for investment grade corporate bonds, which have recorded massive demand this year as investors seek higher returns than safer Treasuries, returns have been minus 2.3% so far this year.

'LOWER CONFIDENCE'

Still, as yields creep back to 5%, several bond investors say they are not panicking and favor interest rate exposure even if holding those positions could be painful in the short term.

"We like the duration trade and we don't see rates going up that much more," said Alex Morris, chief investment officer of F/m Investments. "Being a little early to that trade is okay, and right now you get positive real yields because actual coupon rates are high enough that you're getting paid to do that trade, so it's okay to hang out there," he said.

Of course, not everyone agrees.

Investors are less optimistic on inflation falling, with 38% expecting lower yields over the next 12 months against 62% in December, according to a fund manager survey by BofA Securities. Allocations to bonds this month recorded the biggest month-on-month drop since 2003, it said.

Meanwhile, traders of futures tied to the Fed's policy rates on Friday expected less than two interest rate cuts in 2024 - the most hawkish outlook for interest rates so far this year.

The peak in yields last year preceded a rally in bonds that was supported by inflation coming down and the Fed messaging it was time to move toward a more dovish direction.

This time around, after three consecutive upside surprises in inflation, confidence that price pressures are easing is lower, said Anthony Woodside, head of U.S. fixed income strategy at LGIM America.

"It's a little too early to extend duration," he said.

(Reporting by Saeed Azhar and Davide Barbuscia; editing by Megan Davies and Josie Kao)