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Yields surge as new regime plays out

Wed 18 Oct 2023

Yields on benchmark 10-year U.S. Treasuries last week briefly rose to 16-year highs above 4.50% as major central banks paused rate hikes but left the door open for more.

Markets are coming around to our view that rates will stay high – and now even exceed our expectations in Europe. Rising long-term bond yields show markets are adjusting to risks in the new regime of greater macro and market volatility. We get granular in bonds and equities.

Going up

U.S. Treasury yields and policy rate, 1985-2023

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Source: BlackRock Investment Institute, with data from LSEG Datastream, September 2023. Notes: The chart shows the yield on the Datastream 10-year Benchmark Treasury and the U.S. Federal Funds rate.

All eyes initially were on monetary policy last week amid a blitz of central bank decisions. Then the main story quickly became surging 10-year bond yields to 16-year highs (dark orange line in chart) – even as the Fed and other central banks left policy rates unchanged (yellow line). We think the market is adjusting to the new regime and its implications – especially higher macro volatility. This is bringing to light just how uncertain the outlook is as well as the risks to longer-term bonds. As markets adjust to the new regime, we see opportunities. We’ve turned positive on long-term UK gilts and European government bonds, where that adjustment is more advanced. But we’re not yet ready to jump back into long-term U.S. Treasuries. We think term premium – the compensation investors seek to hold long-term bonds – can return and push yields higher still, as can quantitative tightening and the step-up in Treasury issuance.

Rate hikes are weighing on economies. Major central banks are administering the medicine of tighter monetary policy and economies have slowed. The medicine is still working its way through the system – and effects have varied across regions. PMI data across Europe has shown stagnation. GDP data suggest activity has held up in the U.S. But we think activity has actually stagnated there as well. That seems to have gone under the radar: a stealth stagnation. The average of GDP and another official measure of activity, gross domestic income, shows the U.S. economy has flatlined since the end of 2021.

Central bank blitz

The market narrative hasn’t been one of U.S. stagnation though. One reason: We’ve avoided the short and sharp drop of recession for now. Instead, it’s felt like a rolling effect of hikes rippling through the economy – that may be why the market feels different, too. The weakness we’re seeing isn’t a normal business cycle slowdown, in our view. Unemployment is still low. That suggests something structural is at play, so we don’t think a purely cyclical lens applies. We’ve long said we’re in a world shaped by supply – and this is playing out. We see constraints on supply building over time – especially from a shrinking workforce in the U.S. as the population ages. Central banks need to keep a lid on growth to avoid resurgent inflation once pandemic-era mismatches unwind. That’s why we see them holding tight, not cutting rates like they did in past slowdowns.

Our long-held underweight to long-term U.S. Treasuries has served us well as yields climb. Markets have come around to our view on policy rates. Yet there is still little term premium. We prefer short-term Treasuries given comparable income to high-quality credit without the same credit or interest-rate risk. We also like long-term bonds in Europe and the UK. Ten-year yields there are around three percentage points higher than the pre-pandemic average, versus about two in the U.S.

Japan stands apart. First, the Bank of Japan is seeking to ensure it has got inflation up sustainably to 2%. Keeping policy unchanged last week suggests it would rather hike too late than risk being too early. Japanese bond yields have been relatively stable, but we expect a jump as suggested in market pricing with the BOJ loosening its yield cap over time. Second, Japan is not suffering the same structural downshift in growth – and corporate reforms are taking shape. We think strong growth can boost earnings and shareholder-friendly actions may keep attracting foreign investors to Japanese equities.

Bottom line

Bond yields are surging as the market adjusts to the implications of the new macro regime. We tactically prefer short-term bonds in the U.S. for income, long-term bonds in Europe and the UK – and Japanese stocks.

Market backdrop

The 10-year U.S. Treasury yield jumped to 16-year highs and U.S. stocks slumped over 2% last week – with the S&P 500 steadying some on Friday after its worst day since the March banking tumult. The Fed, the Bank of England and BOJ all kept rates unchanged. We think surging bond yields show markets reassessing the greater uncertainty and volatility in the new macro regime. We expect persistent inflationary pressures to play into this as demographic changes start to bite.

U.S. and euro area inflation is in focus this week, including the Fed’s preferred PCE gauge. Inflation has cooled as the spending shift back to services helps resolve some the pandemic-era mismatches in supply. But we expect core inflation to stay on a rollercoaster as aging populations keep the labour market tight and keep up inflationary pressures.

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