On the day, position shifts by two well-known investors—Bill Ackman of Pershing Square Capital Management and PIMCO co-founder Bill Gross—helped turn sentiment in a positive direction. But while position changes can help shift near-term momentum, this leaves the question of what has been driving yields higher and where yields are likely to go next.
How did US 10-year yields get to 5%?
The 10-year yield has three drivers: policy rate expectations, the natural rate, and the term premium.
First, Federal Reserve policy rate expectations have repriced to a “higher-for-longer” scenario for 2024. The US economy has proved more resilient and inflation more persistent than previously expected, leading the Federal Reserve to raise rates higher, and recently, to suggest it will keep them higher for longer.
Second, resilient consumption growth and fiscal expansion—which amount to lower savings/supply of funds for a given level of investment/demand for funds—have resulted in an increase in market-based gauges of the real natural rate. (This equilibrium rate is the sum of the real rate at which the economy can enjoy both stable prices and full employment and the inflation target.)
Third, the term premium—the extra compensation investors require to hold longer-term debt instruments rather than a series of shorter-dated ones over the same period—has been rising recently as bond markets are starting to challenge a deteriorating US fiscal position.
Where do we go next?
From here, our view is that we are now close to the peak in yields.
First, policy rates are peaking. Market-based expectations for the terminal Fed policy rate have been stable in recent months, supporting the view, also expressed by Fed officials, that rates are close to the peak. We have not changed our opinion that the transmission of those rates, which are in restrictive territory, will exert downward pressure on growth and inflation over our six- to 12-month tactical horizon. Lower growth and inflation in turn should allow yields to fall.
Second, we do not think the natural rate is structurally higher. In the longer term, the natural rate is influenced by a variety of factors including demographics, debt levels, and productivity. Looking ahead, these structural factors, which have weighed on the natural rate, remain intact.
Third, the term premium. In the face of a deteriorating US fiscal position, but without the support of quantitative easing bond purchasing programs, investors are being rational in demanding more compensation for long-term lending. In the near term, we cannot exclude the risk that the term premium might rise further, with a complicated political situation in the US giving us little confidence that fiscal policy is going to be tightened any time soon.
But a large move higher, particularly if it were rapid, would risk impairing Treasury market functioning and raise financial stability issues. This would likely prompt Fed intervention in the form of liquidity support (like in March with the US regional banks crisis). In our view, the term premium is unlikely to rise back to levels observed in the 25 years prior to the GFC of between 1–3% compared to around 50 basis points at present.
How do we invest?
We retain a preference for high-quality bonds in the 1 to 10-year maturity segment, particularly the five-year point since running yield and capital upside should quickly reverse recent drawdowns over our tactical investment horizon. Despite a move higher in yields of nearly 100bps, the total return on a five-year high-quality bond investment is essentially flat, demonstrating how higher outright yield levels can protect against mark-to-market volatility.
Given the risk that term premiums might increase further, we have implemented a steepening trade on the US yield curve, buying five-year US Treasury bonds and selling 10-year ones.
The most severe drawdowns in high-quality bonds have been in the ultra-long end of the curve, which traditionally has exhibited much more sensitivity to technical supply/demand factors than pure macroeconomic factors. Here we continue to exercise caution.
