Higher CPI shows that rates volatility will remain elevated. Higher CPI shows that rates volatility will remain elevated. Higher CPI shows that rates volatility will remain elevated.

Higher CPI shows that rates volatility will remain elevated.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Economic data show a continuation of the 2023 macroeconomic trends, putting the December Federal Reserve's pivot at odds. Sticky inflation might call for a slower adoption of easy monetary policies, threatening long-term fixed-income securities. On top of it, the US Treasury is looking to increase coupon issuance in the second quarter of the year to levels seen only during the COVID-19 pandemic, creating a floor below which US Treasury yields are unlikely to dive. From a diversification perspective, we continue to see value in 10-year US Treasury bonds but remain cautious on ultra-long duration.


After a strong bond rally, which took 10-year yields from 5% to 3.78% during the last quarter of the year, yields resumed their rise, breaking above 4.20% again.

The bond market is responding to economic data, which shows a continuation of the 2023 macroeconomic trend. Economic growth has remained above trend for six quarters in a row. The labor market is tight, with nonfarm payrolls exceeding any economist's expectations in January and yearly wage growth remaining a couple of percentage points above pre-COVID averages. Disinflationary trends are disappointing expectations, indicating that the fight against inflation is still ongoing, and it may take a longer period of above-average interest rates to see inflation fall to 2%.

The above picture is at odds with the Federal Reserve's December pivot, which led bond futures pricing up to seven rate cuts for this year. Now, bond futures expect the Fed to cut rates less than four times, close to what the dot plot showed last December, but that doesn't mean the bond market will be less volatile.

Why is the yield curve bear flattening again?

The yield curve bear-flattens when the front end rises faster than the long end. Such a move tells us that the bond market expects the Federal Reserve to be less aggressive than anticipated and rates to remain "high for longer," causing the economy to slow down. The long end is not rising as much as the front end because fears of something breaking increase. Yet, long-term yields don’t drop: the expectation is for the economy to fare well.

However, such a move is likely to be short-lived. In the December dot plot, the Federal Reserve showed expectations for three rate cuts this year despite, at the time, growth being strong and inflation core and headline remaining well above 3%. The Fed's implicit message is that rates will be cut pre-emptively before inflation reverts to the 2% target. It is, therefore, safe to expect a steeper yield curve with lower front-term yields as the Fed begins to cut rates.

However, the long part of the yield curve remains a wild card, as it is not directly correlated to monetary policies and depends on a number of other factors, such as inflation expectations.

Are 10-year US Treasuries at 4.3% fairly priced?

We see three possible scenarios for 10-year yields:

  1. The fight against inflation is won. The economy enters a recession, calling for aggressive interest rate cuts. In this scenario, 10-year yields can collapse between 3%-3.5%. The reason is simple: the Federal Reserve will cut rates aggressively, reaching the 2.5% longer-term rate target earlier than forecasted. Such a move will result in a steeper curve, where 10-year yields will stabilize 80bp to 100bp above the dot plot’s longer-term rate.
  2. The fight against inflation is won. The economy remains underpinned, and the labor market is tight. In this scenario, markets must consider a higher, longer-term neutral rate. If that were around 3%, that would call for 10-year yields of around 4% -4.5 %, which is where they are now.
  3. Inflation remains sticky. If inflation remains a problem, it doesn’t matter whether economic activity is resilient or subdued; in this case, the Fed won’t be able to cut rates consistently, and the risk for the Fed to pivot back into rate hikes remains. Bond futures show the Fed Fund rate will not drop below 3.75% during the next ten years. If that were the case, ten-year yields have room to rise again up to 5% or even higher.

The US Treasury issuance wildcard.

As the Federal Reserve prepares to cut rates, the US Treasury is preparing to increase the issuance of coupon bonds and notes (US Treasuries with two or more years of maturity).

Although the monetary policy path ahead remains uncertain today, what is certain is that the US Treasury will need to increase coupon issuance next quarter and for the rest of the year.

The latest financing indications of the Treasury Borrowing Advisory Committee (TBAC) show that coupon issuance will increase to a little over $1 trillion in the year's second quarter. In May alone, the TBAC suggests selling $368 billion worth of coupon notes and bonds, just $7 billion below the pandemic monthly peak.

Although we do not see issues concerning the placement of such instruments, supply will create a floor below which long-term rates will not be able to drop.

Yet, we must recognize the possibility of issuance becoming an issue if inflation remains sticky. If that were the case, bond vigilantes might demand higher term premiums, causing long-term yields to rise sharply. 

What does that mean for my portfolio?

US Treasury is still a valuable tool to diversify risk in one's portfolio. Disinflationary trends and a less aggressive Federal Reserve calls for duration extension. However, sticky inflation might call for slower adoption of easy monetary policies, threatening long-term fixed-income instruments. We see value in 10-year US Treasuries as they offer an appealing risk-reward ratio. Assuming a one-year holding period, if 10-year yields rise by 100bps to 5.3%, one would record a loss of -2.7%. However, if yields drop by 100bps, such a position will gain roughly 12%. We call for caution for ultra-long maturities, as the performance of these instruments relies on fast and aggressive rate cuts.

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