It’s premature to call off a recession
Lower shelter costs will ease inflationary pressures
Treasury supply dynamics caught the market by surprise
“Toto, I’ve a feeling we’re not in Kansas anymore.” This famous phrase from the Wizard of Oz, which coincidentally celebrates its 84th anniversary this week, echoes the prevailing sentiment in the bond market these days. Much like Dorothy, who was swept away in a tornado to a completely unfamiliar place, bond investors have been faced with a similar new reality after this year’s surge in interest rates. The rapid rise in yields over the last 12 weeks, primarily led by longer-dated maturities, has been unnerving for investors. After all, this is not how 2023 was supposed to go, particularly in an environment of slowing economic growth, disinflation and the Federal Reserve (Fed) nearing the end of its tightening cycle. So, what is behind the recent rise in Treasury yields? Here are four contributing factors driving the move, along with our outlook.
Positive macro surprise fuels higher yields | Despite consensus calls for a recession and a deeply inverted yield curve, economic growth has defied expectations. In fact, 1H23 economic growth was above potential at an ~2% annualised pace. And 3Q appears strong, with the Atlanta Fed GDP Now model predicting a robust 5.9% growth rate—a remarkable pace given the ~525 basis points of Fed tightening in the pipeline. This resilience has been a major factor driving the 10-year Treasury yield from a low of 3.3% in early April (when banking sector fears were elevated) to ~4.2% today. But as the consensus has shifted from a recession to ‘soft landing’ narrative, there are a number of headwinds (i.e., student loan repayments, higher borrowing costs, slowing job growth) that could turn the recent string of positive economic surprises in the opposite direction and serve as a catalyst to take yields lower. We think it’s premature to call off a recession and expect the economy to experience a mild recession in 1Q24.
Inflation uncertainty and peak disinflation | Although inflation has decelerated from a peak of 9% to ~3%, the market remains fearful of a second wave. Concerns about the path of inflation in the medium term due to structural shifts (i.e., supply chains, rising labour strife, energy transition) are adding to the uncertainty. And with upside risks to inflation flagged in the July FOMC minutes, commodity prices (particularly oil) moving higher, and the favourable base effects (i.e., easy YoY comparisons) fading, inflationary fears have sent yields higher. We believe those fears are overblown as the dis-inflationary trend should continue as lower shelter costs begin to feed into the numbers. In fact, a recent NY Fed research paper surmised that shelter costs could turn negative by mid-2024. If correct, lower shelter costs should ease inflationary pressures further as they make up nearly one-third of the index. As inflation resumes its downward trend (after the recent temporary pause), yields should move lower as well.
Fiscal dynamics move to the forefront | Fitch’s downgrade of the U.S. government’s credit rating last month reignited concerns that the federal deficit and the trajectory of the U.S. government’s debt (which we’ve flagged in the past) are on an unsustainable path. While the Fitch decision may have provided a catalyst for the recent sell-off, the government’s larger than expected budget deficit (thanks to rising debt service costs, lower tax receipts and higher federal outlays) was likely a bigger factor. The Treasury Department’s announcement of $1 trillion of new borrowing in 3Q and an additional $0.85 trillion in 4Q have likely been a root cause. While supply dynamics have historically taken a back seat to macro fundamentals, the prospect of persistently higher Treasury issuance caught the market by surprise. Historically, these concerns have proven temporary as long as demand for U.S. Treasury remains robust. And we have not seen demand wane in the recent auctions and do not expect to see a big drop-off going forward. As a result, a return to fundamentals (e.g., mild recession) should drive yields lower.
Bank of Japan’s yield curve tweaks | The Bank of Japan took another step toward normalising monetary policy, by relaxing the cap on its 10-year yield allowing it to trade in a range of 0.5% to 1.0%. The announcement pushed 10-year Japanese government bond yields 22 bps higher to 0.68%. This spilled over into the global bond markets, pushing G-10 yields sharply higher on fears that Japanese investors (our largest creditor) would sell U.S. Treasuries and buy their own bonds. We think this knee-jerk explanation is an excuse to justify the recent sell-off. And while Japan’s holdings of U.S. debt has moderated over the last year, foreign appetite for U.S. debt has not waned. In fact, the number of indirect bidders (foreign purchasers) has increased at recent auctions (from 58% five-years ago to 69%), suggesting that foreigners are not backing away from purchasing Treasuries.
Bottom line | We remain optimistic that longer-maturity yields can move lower in the months ahead as the macro dynamics are set to become supportive of lower interest rates. However, to achieve our 3.25% 10-year Treasury yield 12-month forecast, we’ll need to see economic data start to weaken and the Fed end its tightening cycle (which we believe is nearing an end). A capital gain opportunity will arise when the Fed starts to cut rates, which is possible in 2H24. But, with the 10-year Treasury yield now above 4% – the highest level in 16 years – Treasury yields (and high quality bonds in general) are attractive at current levels.
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