Bonds are not rallying with positive inflation news
Poor technicals are driving market moves
Dysfunction in Washington remains a wild card
Swing and a miss! This week marks the start of post-season baseball—America’s favourite pastime. Over the next four weeks, twelve of the best teams (although four have already been eliminated) across the league compete to win this year’s championship. With the playoffs underway, baseball fans across the nation will be rooting for their favorite team to advance. And all eyes will be watching whether the reigning Houston champs prevail or will an underdog team (let’s go Baltimore!) pull off an improbable win? And speaking of a swing and a miss, forecasting the peak in the 10-year Treasury yield during this economic cycle has been a humbling experience, at best, these days. But after the brutal sell-off in Treasury yields over the last few months, the key question is how much higher can yields go from here? Calling the precise level where yields will peak in a momentum driven market is challenging, but there are some key factors that should provide guidance on where interest rates go from here.
Bond Market Not Rallying On Fundamental Drivers | The recent repricing in longer-maturity yields has pushed the 10-year Treasury yield to levels not seen in 16 years. And while the speed of the moves is unnerving, the upward march in yields appears to be disconnected with fundamentals. Yes, the U.S. economy has been stronger than expected. But the robust economic activity we saw over the summer is fading quickly as consumer headwinds mount. In addition, the sharp acceleration in yields over the last month or so has occurred at a time when there has been better than expected news on the inflation front (falling core PCE), no sign of a rebound in copper prices (a key barometer of global economic health) and a sharp decline in the prices paid sub-component of the ISM Manufacturing Index. From our vantage point, these data prints do not convincingly align with the ‘higher for longer’ messaging from the Fed. The problem: the market appears to be convinced that the Fed’s higher for longer messaging means that interest rates are going to remain higher forever! While we agree that a move back down to pre-pandemic lows of 0.5% on the 10-year Treasury yield is unlikely in the upcoming cycle (or else we would have much bigger problems to worry about!), we believe the market is overestimating the strength of the economy and ignoring the continued progress being made on the inflation front.
Poor Technicals And Indiscriminate Selling Exacerbate Market Moves | The move in bond yields has been swift. However, momentum and technical factors suggest that the recent price action may have gone too far for three key reasons. First, 10-year Treasury yields have increased ~130 bps over the last five months. Historically, when the 10-year Treasury yield rises over 1% in such a short period, that tends to signal a turning point or a peak in yields. Second, from a technical perspective, climbing yields have pushed the 10-year Treasury bond into oversold territory (i.e., RSI<30). And when this has occurred in the past, the 10-year Treasury yield has stabilised and moved lower over the next 3, 6 and 12 months. Lastly, there does seem to be indiscriminate selling across equity sectors that are tied to the bond market. When breaking down the performance of S&P 500 constituents, the top 20% of S&P 500 companies with the highest dividends have underperformed the S&P 500 by ~20% year-to-date. And the bond proxies, utility and real estate stocks, have been among the worst performers YTD. Typically, when you see this type of indiscriminate selling, it generally suggests the market is nearing an inflection point.
Dysfunction In Washington Remains A Wild Card | While a last-minute deal helped the U.S. government avert a shutdown, the bad news is the threat of another shutdown has not fully receded. The first ever removal of the Speaker of the House this week has thrown more uncertainty into the mix—raising the odds of a government shutdown in mid-November. The political dysfunction is coming at a time when debt dynamics, fiscal spending and an overwhelming amount of Treasury supply are creating worries for investors, rating agencies and voters. Now to be fair, the government’s deteriorating fiscal outlook should place some upward pressure on bond yields—the market’s way of sending a message to Washington that they need to get their house in order. And, the longer the Fed keeps rates elevated to offset the government’s profligate fiscal spending, the worse the fiscal dynamics will get. But, while policymakers were able to spend freely with limited consequences in an era of low inflation and low interest rates, the same can’t be said about today. With the 10-year Treasury yield now hovering near 4.8% (~75 bps higher in the last five weeks) and debt servicing costs rising at a rapid clip, Congress may soon need to make some hard decisions. This means that like it or not, a new era of fiscal responsibility may need to be ushered in. And if this happens, fiscal austerity would be a near-term headwind for growth which could ultimately place some downward pressure on interest rates.
Bottom Line | The abrupt sell off in bond yields does not align with our outlook for a mild (not severe) recession and deceleration in inflation. While rates have likely overshot fundamentals, higher yields and tightening financial conditions will slow the economy and drive yields lower—not back to the COVID level lows, but significantly lower (12-month target: 3.50%) than where yields are today
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