(Bloomberg) -- A contrarian call that US bonds will start to outshine German peers is gaining traction, putting at risk one of the most popular bond trades of the year.

Insight Investment Management Ltd has been buying Treasuries and selling European paper, saying markets are pricing too few interest-rate cuts from the Federal Reserve. Toronto Dominion Bank is recommending clients do the same, seeing a risk the European Central Bank will disappoint markets by not delivering enough easing.

The view defies a bullish wager on European securities that took off as the outlook for the euro-area economy began to wane relative to that in the US. Investors started betting the ECB would respond with more rapid cuts and piled into European bonds, driving the yield on German 10-year bonds to around 220 basis points below Treasuries, the widest gap since late 2019. 

But “the market has probably gone a bit too far in terms of pricing out cuts from the US,” said Jill Hirzel, a senior investment specialist at Insight Investment in London. 

The firm, which manages £648 billion ($811 billion) in assets, initiated a long position on US Treasuries versus European equivalents at the front end of the curve to position for the expected rate paths to converge.

Currently, traders favor three quarter-point reductions from the ECB this year and just one from the Fed, which has to contend with persistent inflation and an economy still running at full steam. A 25-basis point cut from US policymakers is now expected only in November, compared to June just a month ago. 

Meanwhile, the market’s conviction of a first move by the ECB in June has proved unwavering. Yet, as the economic picture begins to change, some investors are starting to question what happens beyond that point, especially if the Fed stays on hold this year.

 

The latest round of economic data from the euro area showed the bloc exited recession in the first quarter, with the biggest economies growing faster than expected. Inflation’s retreat toward the 2% goal stalled in April.

“After June, the odds are rising that we have possibly a longer pause, not just in July but longer,” said Adam Kurpiel, head of rates strategy at Societe Generale SA in Paris. “Risks are skewed toward fewer cuts and in particular, there are risks behind the inflation projections from ECB, that they will be skewed to the upside.”

For Pooja Kumra, head of European rates strategy at TD, the ECB may disappoint markets by not committing to consecutive rate cuts after a move in June, while the Fed is likely to start easing in September. 

She recommended on April 24 clients tactically buy 10-year Treasuries against equivalent German bonds, targeting the spread to drop back to 170 basis points in two to three weeks. 

--With assistance from James Hirai and Sujata Rao.

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