Unlocking Treasury Convexity: How Methodology Shifts and Inflation Trends Signal a Bull Market in Intermediate Maturities

The U.S. Treasury's shift to the monotone convex spline (MC) methodology in December 2021 has quietly transformed how yields are calculated—and now, combined with softening inflation data, it's creating a rare opportunity in intermediate-dated Treasuries (3–7 years). This is a market moment where convexity, mispricing, and macro trends align to reward bold investors. Here's why now is the time to act.

The Methodology Shift: Floors, Floors Everywhere, but No Negative Yields

The Treasury's adoption of the MC method replaced the older quasi-cubic Hermite spline (HS), which relied on ad-hoc inputs to fill gaps in issuance. The MC methodology uses real-time bid-side prices of the most recently auctioned Treasuries, eliminating the need for composites or interpolated points. But here's the catch: the Treasury enforces a zero-yield floor for nominal CMT rates, even if underlying market prices imply negative yields.

This creates a disconnect between market reality and published benchmarks. For instance, during periods of extreme demand (like 2022's cash crunch), T-bill yields briefly turned negative in the secondary market. Yet the CMT floor kept published short-term rates artificially elevated. This policy, while necessary for regulatory programs tied to CMTs, leaves room for mispricing in longer-dated Treasuries. The floor artificially “supports” yields at zero, compressing spreads between short- and intermediate-term maturities—a distortion that savvy investors can exploit.

Inflation's Retreat: The Catalyst for a Yield Pullback

The Treasury's methodology isn't the only game-changer. Inflation data has turned decisively softer. The CPI has cooled to 3.2% year-over-year as of April 2025, down from 4.9% in late 2024. Core inflation, excluding volatile food and energy, is now below 3.5%—well within the Fed's tolerance zone. This has sparked a quiet shift in market expectations: the Fed's terminal rate is now seen at 5.25%, down from earlier forecasts of 5.5%, and rate cuts are priced in by early 2026.

This sets the stage for a bear flattening—a decline in long-term yields outpacing short-term rates. The 10Y-2Y spread, which briefly inverted in Q1 2025, is now narrowing again, signaling reduced recession risks. But here's the key: intermediate maturities (3–7Y) are uniquely positioned to capture this move. Their convexity—the non-linear relationship between price and yield—means they'll rally harder as yields fall than their longer-dated counterparts.

Why 3–7Y Treasuries Are the Sweet Spot

1. Convexity Bonanza: The 5Y Treasury has 50% more convexity than the 10Y, according to J.P. Morgan. A 50-basis-point drop in yields could boost prices by 2–3% more in the intermediate sector.
2. Mispricing from the MC Floor: The Treasury's zero-yield floor keeps short-term CMTs artificially high, compressing spreads against intermediate maturities. This creates a value trap for shorts but a buying opportunity for longs.
3. Inflation's Final Lap: Even if inflation surprises to the upside, the Fed's credibility has been restored. The market is pricing in only 1 rate hike over the next year—making intermediate Treasuries safer than cash.

Action Plan: Buy Now, Capitalize on the Pullback

• Target: Buy 3–7Y Treasuries with durations of 4–5 years. Focus on on-the-run issues (e.g., the 5Y note, CUSIP 912828Y55).
• Avoid: Steer clear of ultra-long Treasuries (10Y+). Their convexity benefits taper at lower yields, and their prices are already discounting a Fed pivot.
• Monitor: Track the 3Y-5Y swap spread for confirmation of flattening trends. A narrowing spread signals the setup is intact.

Conclusion: The Yield Curve's Next Move is Clear

The Treasury's methodology shift and the inflation slowdown have conspired to create a sweet spot in intermediate-dated bonds. The MC floor may keep short-term yields artificially elevated, but the market's focus is shifting toward a Fed easing cycle. This is a once-in-a-cycle opportunity to lock in gains via convexity—before the next leg of the bond rally unfolds.

Act now: Positioning in 3–7Y Treasuries isn't just a bet on falling yields. It's a bet on the Treasury market's own rules—and the math of convexity—working in your favor. The yield curve is whispering: “Buy the middle.”