Still expect U.S. yields to trend lower over next 12 months
- Last week, the 10-year U.S. Treasury yield (now trading at 4.04%) jumped above 4% for the first time in four months. Between early March and late June, the 10-year chopped between 3.4-3.8%, before rising more than 0.35% over the past week and a half.
- Yields across the curve are rising for a variety of reasons: 1) growing conviction that the Fed’s hiking cycle is not complete; 2) resilient U.S. jobs data postponing calls for a recession; and 3) plans for massive U.S. Treasury debt issuance in 2023-24 that could deliver a gut-check for demand.
- Above-target inflation and sturdy wage growth will likely spur the Fed to deliver another 0.25% rate hike in July. However, based on prior cycles, the 10-year yield tends to stop rising shortly before the final rate hike. More likely than not, we are nearing that point, dampening our expectations for significantly higher yields. Cooler inflation data, slower growth, tighter lending practices, and restrictive Fed policy should also mitigate upward yield moves.
- Income is a crucial component for bond total returns. 10-year yields are close to their highest point in more than a decade. At 4%, 10-year yields could climb almost 50 basis points (0.5%) further and still deliver slightly positive the 10-year yield tends to stop rising shortly before the final rate hike total returns over the next year. However, we continue to expect U.S. Treasury yields to trend lower (i.e., prices rise) over the coming year.
- We recommend setting duration slightly long (0.25 to 0.50 year) of intermediate benchmarks. A “barbelled” portfolio structure (exposures to both the short and intermediate regions of the yield curve) is compelling. It captures the highest short-dated yields in more than 20 years, while adding exposure to longer dated bonds which tend to significantly outperform as the U.S. economy shows signs of weakness. We reiterate our bias for higher quality fixed income sectors, such as U.S. Treasuries and investment grade munis. Elevated valuations in some of the riskier corners of fixed income appear too complacent relative to deteriorating leading indicators of economic activity.
- Low liquidity as a result of the Fed’s balance sheet reductions (i.e., quantitative tightening), rapid U.S. government debt issuance, and seasonal effects on trading volume during the summer months pose risks to our yield outlook. These conditions can result in periods of reactionary overshoots. However, higher yields would likely invite stronger domestic and international interest, thereby capping upward yield momentum based on broader demand.
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