Fixed income perspective – from the Investment Advisory Group

Executive summary

• The 1- to 5-year region of the U.S. Treasury yield curve is the most attractive after six months of market re-positioning for aggressive Federal Reserve (Fed) rate hikes.
• We believe the 5- to 30-year segment of the curve has further to rise, but the magnitude of the move will be much smaller than what we’ve endured since mid-2020.
• We would maintain a neutral duration posture in anticipation of better opportunities to extend duration, perhaps later this year.
• The primary risk to our current view is if inflation fails to cool as we expect. This would lift inflation expectations and raise the projected terminal setting value for the Fed funds rate.

What happened

On Monday, June 6, the 10-year U.S. Treasury yield closed above the 3% threshold, exactly one month after briefly touching 3.2%, the highest intraday level since late 2018. The return to 3% territory is consistent with our view that intermediate and longer yields have further to rise. However, relative to the upward move since mid-2020, we believe the majority of the move higher is in the rear view mirror. This is especially true in the 1- to 5-year range where our belief in “peak” inflation and overly hawkish Fed rate hike expectations suggests yields are even closer to their cycle peaks. In the first 12 months of the curve, yields have remained relatively dormant. That should change as the central bank raises the Fed funds rate several more times.

Our take

\While an oversimplification, it is useful to look at the U.S. Treasury yield curve in three distinct segments and analyze the primary forces driving their behavior. Within this framework, we can piece together how the yield curve will likely evolve through the rest of the year.

The first 12 months – This region of the yield curve largely reflects Fed rate policy in real time given its short-investment horizon. While the Fed discussions have intensified around raising the Fed funds rate to combat strong inflation, the Fed has only raised its policy rate by 75 basis points (0.75%) to a range of 0.75-1.00%. As a result, yields in the very front end of the curve remain suppressed. As the Fed executes additional hikes throughout the rest of this year, we expect short yields to extend their rise.

The Fed uses the spread between the 3-month (1.24%) and 10-year yield (3.00%) to help gauge when monetary policy is becoming restrictive. The 176 basis points (1.76%) differential between the two suggests the Fed has ample room to raise the Fed funds rate before overly compressing this portion of the curve. As the Fed tightens, we expect this portion of the curve to flatten (i.e., the 3-month to rise significantly more than the 10-year). As this plays out, the Fed may start to adopt a more cautious rate strategy to prevent inverting the 3-month and 10-year yield curve. Therefore, we recommend patience with respect to new purchases in the first 12 months of the curve. Following the next few Fed rate decisions, we expect to see more compelling entry points for new investments.

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