Yesterday's lower-than-expected US CPI number provoked a considerable rally in bond and stock markets. Ten-year US Treasury yields dropped to 4.42%, the lowest since September, entering bearish territory, which could take them further down to test resistance at 4.36%.
Bond bulls are claiming victory, saying this is the beginning of the great bond bull market. I hate to disagree, especially when part of that notion is correct: we are definitively heading towards a bond bull market; however, it might be too early to call it as such.
The reason is simple: the bond market is trading on a lot of assumptions, such as that (1) the Fed is done hiking rates and that it is more likely to cut than hiking, and (2) a recession is inevitably on the way.
The problem with those assumptions is that they are highly biased.
Even though it is common sense to assume that record-high real rates will slow down the economy, growth remains above average even seven months after the Fed Fund rate has been raised to 5% and above. By the end of the year's third quarter, the US real GDP grew by 4.9%, when economists expected it to be at 2.9%. Real GDP is now projected to rise 2.2% during the last quarter of the year, in line with pre-COVID averages. However, it’s hard to ignore that GDP surprises have been significant this year and are still propelling the equity market higher, making the case for an imminent recession weaker. Today, the economy continues to surprise on the upside, with retail sales proving more resilient than expected and the Empire State Manufacturing survey showing that business activity in New York State has grown to the highest since April.
The other problem is that the recent bond rally speculates that the Federal Reserve will cut rates to maintain the Fed Fund rate in restrictive territory, but without increasing real tightening further. This point is arguable. During the SVB crisis in March, the actions of the Federal Reserve were clear: the central bank preferred to use its balance sheets to avoid a crisis rather than tweak rates. Indeed, in March, the central bank hiked by 25bps to 5% regardless of speculations that another financial crisis was underway. The point is that even this time, the Fed will tread carefully and might only start a rate-cutting cycle if there is a drastic contraction in growth. The reason is obvious: if the market were to position for rate cuts beforehand and rates to drop, that might work against their aim to return to a 2% inflation target.
Therefore, as the economy remains on its feet and core inflation is still double the Fed's target, the market will likely reconsider interest rate cuts priced in for 2024, pushing yields back up. Ten-year yields are likely 5% once again, which is consistent with fundamentals. Let's consider nominal yields to be an expression of the nominal growth of the country, with inflation around 3% and real growth above 2%. It's fair to pinpoint 10-year US Treasury yields around 5% and even slightly above. The situation will be different as we enter the second quarter of 2024 when the growth will decelerate markedly. At that point, yields will start to fall, and they will fail to boost the stock market.
Yet, denying the attractive risk-reward rating that a 10-year US Treasury brings to one portfolio is impossible. At 4.5%, considering a 1-year holding period, they will provide a 12% total return if rates drop by 100bps and only -2.5% if rates rise to 100bps. That's why we see value in building a barbell, looking at the front part of the yield curve up to 3-year and the 10-year tenor.