Head of Fixed Income Strategy
Summary: The recent rise in long-term US Treasury yields tightened financial conditions further, granting a pause at this week’s FOMC meeting. As the hiking cycle ends, the focus shifts toward how long rates will remain elevated. The 3-month SOFR curve underpins long-term US Treasury yields as it suggests that this is the peak in the interest rate hikes, but rates will not drop below 4.10% during the next decade. For a bond bull market to materialize, long-term benchmark rate expectations must drop to 3% or below. As inflation remains elevated, such a scenario remains improbable. Yet, if a deep recession of credit event materializes, the odds for a more aggressive cutting cycle will quickly adjust. Within this environment, we favor a barbell strategy with a particular focus on maturities up to 3-year and the 10-year tenor.
A pause at this week's FOMC meeting will not surprise markets, as several Federal Reserve members advertised it. Their message is simple: as long-term yields rise, financial conditions will tighten further and work as a substitute for further interest rate hikes.
Since the September Federal Reserve meeting, 10-year yields have risen by around 50bps to 4.9%. The move has been entirely caused by an acceleration of real rates, which rose from 2% to 2.5% during the same period. Meanwhile, breakeven rates remained stable, providing relief among policymakers, which saw inflation expectations gradually rising from March.
Ahead of the FOMC meeting, bond futures suggest that interest rates have already peaked. With mortgages and car loans at 8% and lending standards considerably tighter, it's hard to expect the central bank to be willing to curb financial conditions further. As inflation remains well above target, the Fed can only hold rates higher-for-longer, hoping for an upcoming shallow recession.
The 3-month SOFR curve shows that the Fed will cut rates only three times in 2024, beginning in June. More interestingly, bond futures show that rates will not dive below 4.10% throughout the next ten years. Such a scenario doesn’t leave space for a bond bull rally, as at 4%, rates will remain at the highest since the global financial crisis. As the long part of the yield curve needs to reprice above this rate, it’s fair to expect long-term US Treasuries to remain around or slightly above current levels. Historically, 10-year yields are priced between 100 to 150 bps above the Fed Funds Target rate. Therefore, we could comfortably have 10-year yields trading rangebound between 5% and 5.50% for some time if the benchmark rate remains elevated. Already by now, the yield curve is disinverting. With 3-month T-Bills at 5.30%, it's not unimaginable to see 10-year yields rising toward this level as the front part of the yield curve remains anchored.
For a bond bund rally to materialize, benchmark rate expectations must drop to 3% or below. That is possible in the event of a recession or a credit event, precisely as we have seen in March on the back of the SVB crisis. At the beginning of May, 3-month SOFR contracts were reflecting market expectations for interest rates to drop to 2.70% by the end of 2024. If those expectations held, long-term yields wouldn't have had scope to break above the 4%-4.5% area.
If inflation remains a concern, keeping hawkish will be critical for central banks across both sides of the Atlantic. At the sign of the end of the hiking cycle, the bond market will position for future rate cuts, resulting in lower yields, which might ease financing conditions and underpin inflationary pressures.
On Wednesday, the US Treasury will release the quarterly refinancing announcement on the back of yesterday's disclosure of the Treasury's financing needs. This report might overshadow the FOMC meeting, as it is becoming more apparent that Treasuries are suffering from supply and demand unbalances.
During the past month, almost all the US Treasuries coupon auctions have tailed. A tail occurs when the auction prices at a higher yield than When Issued. Together with dropping indirect bidder demand, that becomes a clear sign of supply and demand asymmetry.
The issue lies in the fact that the US Treasury is trying to sell high volumes of notes compared to pre-COVID, despite traditional buyers of US government bonds having sensibly diminished. The best example is the Federal Reserve, which, through QE, has been purchasing bonds since the Global Financial Crisis until the COVID-19 pandemic. However, the Fed is now a net seller of Treasuries through Quantitative Tightening (QT). Also, foreign investors are buying less US government securities, as the cost of hedging against currency risk has increased dramatically, and they find better investment opportunities at home. Japanese investors are the largest foreign holders of US Treasuries; however, with rising JGB yields at home, it doesn't make sense for them to buy into US or European sovereigns as once hedged against the JPY they provide a negative return.
Compared to the 2010-2020 decade, coupon issuance has increased by around 60% for both 10- and 30-year securities. The Treasury went from selling an average of $22 billion in 10-year US Treasury notes every month before the pandemic to selling an average of $36 billion per month during the last quarter. The belly of the curve, therefore, Treasuries with 5- and 7-year tenors increased by roughly 30% in auction size since pre-COVID.
With a war in the Middle East escalating, and entering into an election year, spending will likely continue to increase, demanding greater borrowing from the US Treasury.
The US yield curve is poised to continue to bear-steepen, unless the market narrative shifts. Within this environment, we continue to favor the front part of the yield curve up to 3-year maturities and the 10-year tenor. Building a barbell will enable clients to take advantage of high yields in the front end while adding protection with 10-year US Treasuries in case a recession materializes.
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