Cautious central banks and decelerating economies take the attention away from inflation.
Spécialiste Fixed Income
Résumé: Central banks on both sides of the Atlantic are done with their hiking cycle as the economy is decelerating. Consequently, bond futures are pricing for more aggressive interest rate cuts beginning next year, bringing yields considerably down across yield curves. Yet the stance of central banks has remained the same. The higher-for-longer message and quantitative tightening still stand while the US Treasury prepares to issue large debt despite sluggish duration demand. Within this context, we remain cautious, favoring a barbell strategy focusing on the front part of the yield curve and 10-year US Treasuries.
Markets are heading toward the weekend with a clear idea: developed central banks on both sides of the Atlantic are done with their interest rate hiking cycle. However, a hawkish bias will be maintained as the fight against inflation is not over.
Central banks' higher-for-longer message explains the bull flattening of yield curves. Typically, the yield curve would bull-steepen as the hiking cycle ends, and investors start to price for upcoming interest rate cuts. However, that didn’t happen this time around because central banks are set for a “table mountain" strategy, as doubted by the Bank of England’s chief economist Huw Pill, which implies keeping the benchmark rate high for long until inflation is clearly under control. Long-term rates dropping faster than short-term rates can be explained by the fact that markets are starting to see a sensible deceleration of developed economies, increasing the likelihood of a recession.
Yet, is the rally that we have witnessed this week sustainable? I don't believe so. The reason is simple: there is too much selling pressure for yields to continue to drop.
The Federal Reserve is proceeding "carefully," while the US Treasury has increased coupon issuance to the highest since 2021.
The most dovish part of Powell's speech is the comments regarding the labor market. He seems to believe that the central bank will be able to fight inflation without slowing down the labor market significantly. That means that there might be no need for labor weakness in order to cut rates in the future. However, these remarks came together with the notion that tighter financial conditions must be persistent; hence, long-term yields need to remain elevated. That keeps the door open to further rate hikes or a potential tweak of quantitative tightening in case long-term yields continue to drop.
Therefore, nothing has materially changed. The Fed remains hawkish, while quantitative tightening (QT) will continue to work in the background, further tightening monetary conditions. That, combined with the fact that the US Treasury will need to continue to expand coupon issuance into the new year while foreign demand for these securities is slowing and the yield curve is steepening (therefore, market participants are buying the front end while selling long end), means that the long part of the yield curve is more likely to rise rather than drop.
Next week, the Treasury is selling $112 billion in coupon issuance, increasing 10-year and 30-year bonds to the highest since 2021. That's almost double what has been issued during the decade preceding Covid. However, the demand side has noticeably deteriorated, with the Federal Reserve turning from a buyer into a net seller.
Supply will continue to weigh on the long part of the yield curve for the next six months unless the direction of monetary policy changes. As long as bond futures are pricing the terminal rate to remain around 4%, 10-year yields will need to price accordingly. Historically, 10-year yields offer a pickup between 100 – 150 basis points over the Fed Fund rate. With rates expected to drop to 3.75% in the next ten years, it would be fair to expect 10-year yields to trade between 4.75%- and 5.25%.
The Bank of England is not credible.
The Bank of England is losing its credibility. Not only is the country suffering from the highest inflation among developed economies, but the labor market will remain tight due to COVID-19. The central banks' economic projections are meaningless and are going through an overall review by Ben Bernanke. Within this context, Bailey is mimicking peers.
With the 3-month SONIA rate showing that rates are not dropping below 4% in the foreseeable future, we can expect long-term Gilts to remain under pressure. It's still very likely that 10-year yields will break above 4.5% as inflation in the United Kingdom becomes entrenched.
The Bank of Japan’s path to normalization underpins higher long-term yields globally.
We must remember that although the Fed, the ECB, and the BOE might be done with interest rate hikes, the BOJ is just joining the party. At this week's monetary policy meeting, the BOJ updated its economic projections, showing expectations for inflation to remain at 2.8% for this fiscal year and the next (therefore, until April 2025) and to drop below 2% only in 2025, revising inflation figures upward every single year. That means the BOJ forecasts inflation to be more persistent than estimated, warranting a normalization of monetary policies. Despite keeping its Policy Balance Rate at -0.10% and its target to 10-year Japanese Government Bond (JGB) yields at 0.00%, the central bank allowed for greater flexibility in bond yields, saying the 1.00% upper bound "hard cap" would become a "reference." Although minor, this step is a sign that policy normalization is in sight and that we are going toward higher JGB yields. Higher JGB yields mean that real money would buy securities at home rather than locking a negative return in USD and EUR sovereigns one hedged against the Japanese Yen. This would put pressure on long-term sovereign bonds on both sides of the Atlantic.
What does that mean for investors?
It means that duration is expensive while the front part of the yield curve has peaked. As I have outlined in this article, the front part of the yield curve allows investors to take minimal duration risk, while maximizing return. Unless yields on 2-year notes rise more than 500bps, investors holding this securities for a year would always be in the green.
The 10-year tenor also brings an attractive risk-reward ratio; however, the longer the duration, the more directional is one's bet. Let's remember that those investors entering long-dated securities at the beginning of the year are now stuck until their position recovers. In order to extend duration considerably, it's critical to see inflation reverting to central banks' target or changing their hawkish posture.