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"Higher-for-longer" means "until-something-breaks"

Bonds
Picture of Althea Spinozzi
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Long-term yields are likely to continue to soar for as long as the Federal Reserve can convince markets it won't need to cut rates aggressively in the foreseeable future. Yet, the intensity of the recent rise in yields calls for a correction, which may come with a government shutdown at the end of the week. Before that, our focus is on the seven-year auction on Thursday, a tenor typically disliked by investors, which could accelerate the bond selloff but may also temporarily halt the rise in yields if investors' demand proves strong. As bonds continue to tumble, the US Treasury benchmark becomes more appealing, paying the highest yield in over a decade while protecting against the risk of a recession. While ultra-long bonds also provide an attractive risk-reward ratio, we remain cautious about duration and prefer the front part of the yield curve.


The intense selloff in long-term US Treasuries comes on the back of last week's FOMC meeting. The market realizes that the "higher-for-longer" message sets a reference point for the whole US Treasury yield curve. Suppose the Fed's economic projections are correct in showing that the economy will remain resilient, unemployment will stay well below the 2010/20-decade average, and inflation will gradually decrease. In that case, there is no reason for the Fed to cut rates aggressively as the market would expect amid a recession. Hence, the 10-year yields will need to price over a much higher expected Fed fund rate.

After the SVB debacle in March, 3-months SOFR futures were pricing rates to fall to 2.7% by the end of 2024. Investors now see the Fed cutting rates only to 4% in the next three years, building a much higher floor for 10-year US Treasury yields, which need to provide a premium above this level. Therefore, the recent move of 10-year yields breaking above 4.5% is justified. The question is whether yields will rise to test 5% and break further up or stabilize below, trading rangebound for a while. Although it's impossible to answer this question accurately, we can look at technical analysis to gauge the intensity of the current momentum to understand better how long it may last. The RSI has been slightly declining while the 10-year yield uptrend continued, indicating that the uptrend is weakening and a slight correction might be due. Therefore, it's fair to expect yields to test support at 4.42% in the short term before resuming their rise and setting above 4.5%, trading rangebound for some time. How high yields can rise above this level depends on how long the economy allows the Fed to keep its hawkish posture. If the signs of a shallow recession don't appear before the end of the year, yields might continue to rise towards 5%. Yet, if economic data get increasingly mixed, it would be fair to see yields trading rangebound well below this level.

26_09_23_AS1
Source: Bloomberg.

The picture is different for 30-year bonds as the RSI confirms the uptrend in yields. Therefore, it won't be surprising to see yields rising to test resistance at 4.79%.

26_09_23_AS2
Source: Bloomberg.

This week’s US Treasury auctions will set the tone before a potential government shutdown.

The $134 billion auction of two, five, and seven-year notes may remove or apply further pressure on long-term Treasuries.

Understanding whether demand remains resilient as auction sizes have increased across longer tenors will be critical. Investors’ appetite for the 7-year notes, one of the least liked tenors together with the 20-year, will be particularly important as foreign investor demand has dropped significantly this year, with indirect bidders taking only 13.4% of the issue in 2023 compared to 16.8% in 2022. At the August 7-year auction, domestic buyers came to the rescue of disappointing foreign bidders' demand. Still, if domestic demand wanes too, it may mean that investors are positioning for a further bear-steepening of the yield curve, demanding a higher term premium. On the contrary, if the appetite for the belly of the yield curve increases, it may imply that investors are beginning to position for a bull-steepening, putting a temporary ending to the bond selloff that has taken place after last week's FOMC meeting.

A government shutdown may be beneficial for US Treasuries

Contrary to what many believe, a potential government shutdown and downgrade from Moody's may cause US Treasuries to rally rather than plunge.

A government shutdown will inevitably be a drag on economic growth and will push the unemployment rate up. The longer the shutdown, the greater the severity on the economy. A quick deterioration of the economic backdrop might create an uncertain economic environment for the Federal Reserve’s November 1st meeting, forcing the hand of policymakers to hold rates steady rather than delivering another hike. That will send a positive signal to the bond market as another pause implies that the central bank is finally done with its hiking cycle, provoking a bull steepening of the yield curve.

At the same time, considering that S&P and Fitch have already assigned an AA+ rating to the safe-haven, a downgrade from Moody's might be shrugged off by markets reasonably quickly. A downgrade from Aaa to Aa1 would reinforce the valuations of the other two rating agencies.

Long-term bonds: does it make sense to buy at current levels?

It depends on your market view and how long you want to hold these securities. If you are a long-term investor, it may make sense to increase duration exposure gradually as yields peak. The modified duration of 10-year US Treasuries (US91282CHT18) is around 8%. Yet, if these securities are held for a year, and meanwhile yields rise by 100bps, the total loss of this position would be -2.5%. If yields drop by 100bps, the total return would be 12%. Assuming that rates are about to peak, the risk-reward profile of the safe haven becomes more appealing as yields soar.

When looking at corporate bonds, we prefer quality over junk. As the highest yields in the investment grade corporate bond space are paid in the front and long part of the yield curve, investors might be interested in creating a barbell. Below is an example of well-rated short and long-term USD corporate bonds.

27_09_21_AS6
Source: Bloomberg and Saxo Bank.

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