AGG - Why Rates Are Up And What It Could Mean For Investors

2023-08-12 02:20:00 ET

Summary

• The recent rise in long-term Treasury rates likely resulted from a confluence of factors: Fitch Ratings’ downgrade of America’s credit rating, the Bank of Japan’s relaxation of yield curve controls, higher-than-expected supply of Treasuries, and better-than-expected economic data.
• We believe long-term rates are likely to move higher in the near-term and see potential opportunities in short- to intermediate-term Treasuries at current levels.
• For equity investors, we recommend sticking with quality companies that can maintain profit margins as well as exposure to equal-weighted indexes.

By Gargi Pal Chaudhuri

August started with a 'bang' in the bond market, with long-term Treasury rates rising sharply. The biggest backup in 30-year yields since October 2022 ¹ - just after the Fed issued the last of its three consecutive 75 basis point hikes - reverberated across all financial markets.

So…what happened? Why did long-term Treasury yields surge so quickly? What could this mean for investors?

In our view, the move was triggered by a confluence of four major factors, as detailed below. We believe long-term rates are likely to move higher in the near term and see opportunity in the belly of the yield curve - meaning Treasuries which mature in 3 to 7 years. (See figure 1)

For equity investors, we suggest focusing on high quality companies that are able to preserve margins, as detailed below.

Figure 1: Fixed income yields: 2021 vs. 2023

4 Reasons Why Long-term Rates Are Moving

An improving economic outlook

Economic data has been better than many expected it would be, especially after the Fed's aggressive rate hikes since March 2022.

Consider the following:

• The unemployment rate remains near cycle lows at 3.5%. ²
• June durable goods sales increased 0.6% vs. consensus expectations of a 0.1% gain, while personal spending accelerated to a stronger-than-expected 0.5%. ³
• Second quarter GDP came in at 2.4% vs 1.8% expectations. ⁴
• Second quarter earnings are currently running about 7% above expectations. ⁵

Just two months ago, many predicted the Fed would ease policy this year to combat an expected sharp slowdown in economic activity. ⁶ Fast forward to early August and the first Fed rate cut is now not fully priced in until May 2024. ⁷ Meanwhile, third quarter GDP expectations have been revised higher to about 1.7% - a far cry from the negative prints that were expected at the beginning of the year. ⁸

More supply of Treasuries

On July 31, the Treasury announced it intended to borrow just over $1 trillion in the third quarter, significantly more than the roughly $800 billion that had been expected by many market participants. With supply set to increase rapidly, Treasury yields - which historically have moved in opposition to bond prices - lurched higher.

While the Treasury decided to leave the size of the 30-year Treasury Inflation Protected Securities ((TIPS)) August reopening unchanged at $8 billion, the massive increase in planned 5-year TIPS issuance from $1 billion to $22 billion pressured much of the real rates curve higher.

In fact, the 30-basis point increase in nominal yields was driven almost entirely by the 2-basis point increase in real, or inflation-adjusted, rates. ⁹ While real rates are certainly impacted by supply-demand dynamics, they can be viewed as a proxy for real growth; over the last month, expectations of real growth have moved higher, as show in the chart below. (See figure 2)

Figure 2: Real rates and breakevens

The Bank of Japan relaxed

Only July 28, the Bank of Japan announced plans to loosen its yield curve control and allow the rate on the 10-year JGB to fluctuate up to 50 basis points on either side of its 50 basis point target. ¹⁰ The announcement was generally more hawkish than most market participants had anticipated. Since the announcement, 30-year JGB rates have risen 28 basis points to its highest level in six months. ¹¹ The upward pressure on JGB rates has made them more competitive vs. other sovereign debts, helping to drive global rates higher, including longer-term Treasury rates ¹² .

Fitch takes the U.S. down a notch

On August 1, Fitch Ratings downgraded its long-term credit rating of the United States to AA-plus from triple-A, the highest rating available. Fitch attributed its decision to America's high and growing debt - alongside its "deterioration in standards of governance". ¹³

The U.S. deficit has risen to 6.3% of GDP and looks to widen over the next few years, Fitch wrote, citing estimates from the Congressional Budget Office. ¹⁴ The U.S. has a debt-to-GDP ratio of around 118%, nearly triple the median 39% ratio of other triple-A rated countries. ¹⁵

While the immediate impact of the downgrade was muted, in our view, the timing of the announcement was an amplifying factor in the severity of the sell-off in longer-term U.S. rates. (Read BlackRock's analysis of the U.S. credit rating downgrade .)

What Could Higher Rates Mean For Your Portfolio?

Given the factors cited above, we expect the yield curve to continue to steepen and believe that long-end rates may continue moving higher in the near term. The August CPI report - which showed core CPI decelerating to the slowest pace since October 2021 - further strengthens our conviction that the yield curve will likely continue to steepen. ¹⁶ This has implications for both stocks and bonds.

We believe fixed-income investors should gravitate towards the front end and belly of the Treasury market, where interest rates are higher. The iShares 1-3 Year Treasury Bond ETF ( SHY ) and the iShares Core U.S. Aggregate Bond ETF ( AGG ) may be options for investors to potentially take advantage of this back-up in yields.

We also believe that inflation linked bonds are attractive in this environment of higher-than-expected inflation.

Equities: Quality Is King, But Catchup Trades May Also Work

Within the equity markets, we are telling investors to continue to remain invested but focus on high quality companies that may be able to preserve profit margins.

As we saw in second quarter earnings season, the upside surprises in earnings have almost been entirely driven by improved margins, as Q2 sales/revenue have only modestly beaten consensus. ¹⁷ We expect sales/revenue growth to continue to moderate, so we think it's important to find companies that can durably sustain margins and have high-quality earnings, generated by strong free cash flow. You can gain exposure to those companies in the iShares MSCI USA Quality Factor ETF ( QUAL ).

While the jury is still out on whether we get a soft landing or not, we think investors may also benefit from allocating to those corners of the market that are still "catching up" to the broad year-to-date U.S. market rally. Specifically, we believe investors may benefit from exposure to equal-weighted exposures such as those found in the iShares MSCI USA Equal Weighted ETF ( EUSA ).

What's Next?

Moving forward, we will be watching a few macro indicators to confirm whether the U.S. economy can indeed pull off the fabled soft landing. Importantly, we will be watching the ISM Manufacturing PMI to see if its recent stabilization will evolve into a recovery above 50 - denoting an expansion of manufacturing activity. ¹⁸ We are also watching small business optimism, judging that a durable recovery in the NFIB index above 92 as consistent with a soft landing. The most recent survey, for July, showed small business confidence at 91.9. ¹⁹

© 2023 BlackRock, Inc. All rights reserved.

¹ Source: BlackRock, Bloomberg, as of August 4, 2023. 30-Year treasuries represented by US Generic Govt 30 Yr Index (USGG10Y Index).

² Source: BlackRock, Bloomberg. All economic data as of August 4, 2023.

³ Source: BlackRock, Bloomberg. All economic data as of August 4, 2023.

⁴ Source: BlackRock, Bloomberg. All economic data as of August 4, 2023.

⁵ Source: BlackRock, Bloomberg. All economic data as of August 4, 2023.

⁶ Source: BlackRock, Bloomberg. Fed fund policy expectations based on World Interest Rate Probability Futures from Bloomberg. Expectations cited as of June 01, 2024.

⁷ Source: BlackRock, Bloomberg. Rate cut futures represented by US0AFR MAY2024 Index. As of August 4, 2023.

⁸ Source: Goldman Sachs for third quarter GDP expectations. Bloomberg for consensus GDP estimates.

⁹ Source: BlackRock, Bloomberg. As of August 04, 2023. 30-year TIPS Breakevens represented by USGGBE30 Index; 30-year Real Rates represented by USGGT30Y Index.

¹⁰ Source: Bank of Japan Statement of Monetary Policy , July 28, 2023.

¹¹ Source: BlackRock, Bloomberg, as of August 4, 2023.

¹² Source: BlackRock, Bloomberg, as of August 04, 2023. JGB rates represented by Japan Govt 10-year Index (GJGB10 Index); longer-term Treasury rates represented by US Generic Govt 10 Yr Index (USGG10YR Index) and US Generic Govt 30 Yr Index (USGG30YR Index).

¹³ Source: Fitch Ratings, August 1, 2023. Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ( Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ).

¹⁴ Source: Fitch Ratings, August 1, 2023. Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ( Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ).

¹⁵ Source: Fitch Ratings, August 1, 2023. Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ( Fitch Downgrades the United States' Long-Term Ratings to 'AA+' from 'AAA'; Outlook Stable ).

¹⁶ Source: Bureau of Labor Statistics as of August 10, 2023.

¹⁷ Source: Bank of America Global Research. Earnings Tracker August 6, 2023.

¹⁸ Source: BlackRock, Bloomberg. ISM Manufacturing PMI represented by ISM Manufacturing PMI SA Index (NAPMPMI Index) as of August 04, 2023.

¹⁹ Source: National Federation of Independent Business, Small Business Optimism Index as of August 8, 2023. Small Business Economics Trends | NFIB .

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