SPXB - U.S. Yields: Two-Way Volatility Ahead

2023-10-16 12:32:00 ET

Summary

• We turn tactically neutral long-term Treasuries as markets price high-for-longer policy rates but stay underweight strategically. We cut high-quality credit again.
• U.S. stocks steadied last week as Q3 earnings season started. Ten-year Treasury yields dipped. U.S. core CPI reinforced why we see the Fed holding policy tight.
• China GDP and Japan inflation are in focus this week. We see China on a lower growth path and higher inflation in Japan paving the way for a policy change.

Transcript

U.S. government bond yields are reaching 16-year highs. And that really goes to show that yields are adjusting to this new regime of greater macro uncertainty and higher interest rates.

We had been underweight long-term Treasuries on a six- to 12-month tactical horizon for now three years, but now we’re turning neutral.

1) Yields likely to pause

Since the Fed started hiking rates in March 2022, a large part of the yields pushing higher has been markets pricing in higher policy rates. But now the Fed and other central banks are likely at the end of the rate hike campaigns.

That means yields are likely to pause around these levels, even if they remain volatile given the uncertainty in this environment. The economic damage from higher rates is also likely to become clearer over time.

2) Yields still heading higher over time

A pause in the long-term yield surge doesn’t mean that we see yields falling sharply from here. Nor does it mean that this is a step toward us turning overweight long-term Treasuries.

Recent yields moves have also been driven by investors demanding more compensation for the risk of holding long-term Treasuries - or, in other words, term premium.

We expect investors to demand more such term premium due to the volatility in long-term Treasuries, driven by persistent inflation plus large fiscal deficits and debt issuance. On a strategic horizon, we’re starting to think that we could see 10-year yields at 5% or higher at some point.

3) Turning more underweight investment-grade credit

From a whole portfolio perspective, we balance this neutral stance on long-term Treasuries by turning more underweight in investment-grade credit. We think that investment-grade credit remains tight, too tight.

We think the risks in 10-year yields are now more two-way as central banks are at the peak of policy rate hikes.

So that is a case for turning neutral on a tactical basis. But we still see yields rising longer term - and expect to turn underweight again at some point.

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We have been underweight long-term U.S. Treasuries since late 2020 as we saw the new macro regime heralding higher rates. U.S. 10-year yields at 16-year highs show they have adjusted a lot - but we don’t think the process is over. We now turn tactically neutral as policy rates near their peak. The next step is not overweight: we see investors demanding more compensation for bond risk and stay underweight on a long-run, strategic horizon. We downgrade high-grade credit further.

Yield surge

Notes: The chart shows the yield of the Bloomberg U.S. Corporate Investment Grade Index broken into option-adjusted spread (yellow) over U.S. Treasuries (orange).

We’ve long said higher interest rates are a key part of the new regime. Why? Supply constraints make inflation persistent; bond supply is swelling due to high deficits; and macro and geopolitical volatility abound. That’s why we went underweight long-term Treasuries on a six- to 12-month tactical horizon when yields were below 1%. We expected investors to demand more compensation, or term premium, for the risk of holding bonds. That has started to occur in recent months, but the repricing of Federal Reserve policy rates has been a big part of the yield move (orange area in chart) since the Fed’s first hike in 2022. We see the yield surge driven by expected policy rates nearing a peak. Rising term premium will likely be the next driver of higher yields. We think 10-year yields could reach 5% or higher on a longer-term horizon. Yet, the gap between investment-grade credit and 10-year bond yields hasn’t widened as we expected, so we further downgrade credit.

We now see about equal odds that Treasury yields swing in either direction. In other words, we see two-way volatility ahead. One reason: The Fed is likely nearing the end of its fastest hiking cycle since the 1980s after raising rates into restrictive territory. We see policymakers shifting to assessing financial conditions. Fed officials said last week that tightening financial conditions due to surging long-term yields are likely doing some of the Fed’s work for it. The U.S. economy has already stagnated for the past 18 months after averaging GDP and gross domestic income - which adds up incomes and profits of households and firms. Further damage from rate hikes will likely become clearer over time. We think these conditions bring us closer to when the “politics of inflation,” or pressure on the Fed to curb inflation, will turn into pressure to stop hurting economic activity with tight monetary policy. We still see the Fed holding policy tight to lean against inflationary pressures.

Yield focus

We think long-term yields have not fully adjusted yet. They will eventually resume their march higher as term premium gradually rises, in our view, to account for greater macro volatility, persistent inflation plus large fiscal deficits and debt issuance. In the near term, inflation is easing as pandemic mismatches unwind from consumers shifting spending back to services from goods. We see inflationary pressures on a rollercoaster ride beyond the near term as an aging population shrinks the workforce, fueling wage and overall inflation. That backdrop begs the question: What will be the neutral policy rate that neither stimulates nor slows activity? Drivers of further yield jumps and tightening financial conditions are up for debate, too. These uncertainties are set to create more volatility in the near term, without yields moving in a clear direction.

We fund our tactical upgrade by further downgrading IG credit tactically after recently going underweight last month. Why cut IG and not the lower-quality high-yield credit? We have expected U.S. credit spreads to widen due to rate hikes. Yet, the IG spread has tightened since the Fed’s first hike, while high yield has widened. We also opt to further downgrade IG rather than high yield to avoid reducing our portfolio risk levels and exposure to risk assets.

Bottom line

We turn tactically neutral long-term Treasuries but stay underweight strategically. Instead of IG credit, we tap into quality in short- and long-term Treasuries and U.S. agency mortgage-backed securities (MBS). Agency MBS carry minimal default risk given the implicit protection offered by the U.S. government.

Market backdrop

U.S. stocks steadied for a second week, while 10-year Treasury yields retreated from 16-year highs hit earlier in the month. We think the volatility in long-term yields is likely to persist, even as central banks have likely reached peak policy rates. Fed comments this week that higher longer-term yields were doing the policy tightening work for them helped confirm this. But a renewed surge in U.S. core services CPI excluding housing reinforced why we think the Fed will hold tight on policy.

Asia is in focus this week: China faces weak consumer and export demand, and the economic restart from Covid lockdowns is sputtering. We see the economy resetting lower than the pre-pandemic trend growth rate. Inflation has returned in Japan. We see risks of spillovers to global bond markets as the central bank faces pressure to change its ultra-loose policy.

This post originally appeared on the iShares Market Insights.

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