Chief Investment Strategist
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Yields may be rising, but we still take a neutral view of USA fixed income duration risk for now.
US long-term Treasury yields jumped by 10 basis points last week. This unusually large daily move followed two strong labor market reports, robust corporate supply announcements, and comments from Fed Chairman Powell that the Fed was “a long way from neutral at this point, probably” (emphasis ours). While we don’t expect a further acceleration in the strong pace of US growth, a weaker-than-expected pace of hiring in September seems less believable than the many positive indicators.
Structural factors holding down US interest rates in recent years are fading somewhat. US capital investment has been picking up, while labor force growth has improved slightly. International investor flows into US bonds have been relatively weak while US borrowing has picked up.
With 10-year US Treasury yields rising to 3.2% – their highest since 2011 – the bond market’s action and Fed comments predictably roiled most financial markets globally after a recent respite from rate concerns.
We believed the yield curve was becoming too flat given the strong US growth outlook. As such, we had expected 3.25% to mark a near-term trading range high. For the coming 12-18 months, we are now raising our view of the upper end of this range to 3.75%. This could be reached if confidence in the growth outlook remains strong and any shocks aren’t overwhelming.
Our analysis suggests we should adopt an overweight allocation to long-term US Treasuries if 10-year yields rise above 3.75% given the most likely economic scenarios that would drive such a rise. We believe investors would be wise to take greater fixed income duration risk at that point. Fed tightening has significantly limited increases in long-term rates, flattening the yield curve in every historical cycle. We consider this a cyclical headwind, limiting long rates.
As to where rates may peak, we should acknowledge that no model pre-dating the Global Financial Crisis would have predicted the very lengthy period of US and global interest rates so far below historic norms. The financial crisis itself made a slow recovery inevitable. But the low yield environment has persisted despite the strengthening pace of US growth. This suggests investors should be especially cautious about relying on forecasts.
While yields are rising, we would still take a neutral view of US fixed income duration risk for now. Among the many bonds that have sold off globally, the US municipal bond market now offers a 6% taxable equivalent yield for US taxed-investors, even without going overweight long duration.
Clients can read our full thoughts on these markets in our Global Strategy Bulletin – Learning to Live With US Interest Rate Uncertainty.