Fynsa
September is shaping up to be the worst month of the year for risk assets, but also for the bond market, amid renewed interest rate pressures, given the possibility that interest rates will remain higher for longer, on fears that rising energy prices and a still resilient economy will lead to more persistent inflation, keeping central banks in tightening mode. The trend has also been helped by a growing supply of U.S. debt to finance large fiscal deficits.
Back in early August, we warned that Treasuries looked likely to fall again, amid still-elevated long-term inflation expectations, which, along with concerns about a U.S. downgrade by Fitch Ratings and a spate of Treasury bond sales to cover the federal deficit, could lead to a rise in term premia. (SEE MORE)
Little has been helped by the "still tightening" tone set by the Federal Reserve last week, where despite holding rates steady in the 5.25% - 5.5% range, they still do not rule out a further hike and perhaps more importantly, that rates will remain higher for longer than the markets had anticipated..
The widespread caution among developed market central banks, which remain reluctant to declare victory in their fight against inflation and maintain a tightening bias, can be justified on the grounds that they had to respond to an inflationary shock not seen in decades and, therefore, need to gauge confidence in the effectiveness of monetary policy after a long period of very low rates.. Second, central bank caution in maintaining a tightening bias also helps to anchor inflation expectations. And thirdly, excessive confidence and clarity that the tightening cycle is over could contribute to a premature easing of financial conditions, which can test inflation dynamics.
Recent concerns about U.S. federal debt may also be affecting U.S. Treasuries and increasing term premiums on long-term bonds. The term premium, a key measure of how much bond investors are compensated for holding long-term debt, turned positive for the first time since June 2021, underscoring the likelihood that interest rates will stay higher for longer (see Chart No. 1).
This has resulted in the U.S. yield curve steepening (see chart). (see chart No. 2) on expectations that the Fed is almost done raising rates, and with the 10-year Treasury yield exceeding 4.5% for the first time since 2007.
There could be a much simpler, though related, reason: A "catch-up" of rates to slightly more persistent long-term inflation expectations, as seen in Chart N°3. That said, inflation expectations would have to "de-anchor", say above 2.5%, to justify further compensation going forward.
Now, the general narrative from central banks suggests that they are pausing - or close to pausing - based on a few considerations. First, developed market central banks, except for the Bank of Japan, have applied between 400 bps and 550 bps of cumulative tightening since the beginning of the tightening cycle and now consider current levels to be sufficiently restrictive. Second, all central banks are aware of the long and uncertain lag in monetary policy transmission. The tightening levels reduced the need for additional tightening unless data question the path of inflation's return to target and/or appear too slow. Third, they believe that keeping the rate higher for longer will eventually help inflation return to target.
In particular, for the US case, given the speed and magnitude of this rate hike cycle (+550 bps), which started in March 2022, and the natural lag with which monetary policy acts, which should start to be felt more strongly in activity data from 4Q23 onwards, we expect the current cycle of monetary tightening by the Fed to be nearing its end.
Finally, after a 50 bp hike in September alone on the 10y treasury, How much do current long-term rate levels or further increases begin to be justified going forward?
Following the logic of the term premium, between 2004 and 2006 at a time when long-term yields were at a similar level to today, the term premium between 10-year and 2-year bonds averaged 40 bps. If the term premium were to return to that level, the 10-year yield would approach 5%, although that would likely only happen if the data continues to point to improving strength in the economy. Otherwise, a rate around 5% is a "bounded downside" considering recent highs near 4.7%.
And as can be seen in Chart N°4, long rates have remained bullish at a time when economic data have again started to surprise on the downside in the US and inflation expectations remain well anchored despite the sharp rise in oil prices in the last few weeks (see chart N°5).
In our base case, we expect some moderation in yields in the coming months and recommend considering a gradual move out of cash into longer maturities and corporate bonds. and we recommend considering moving gradually out of cash into longer maturities and corporate bonds. We will elaborate on this in a future opportunity.
