Head - Fixed Income Strategy
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The 10-year yield has reached multi-year highs. We believe that its rise may not be over.
Long-term US Treasury yields are again making headlines, with the 10-year benchmark yield reaching a seven-year high of 3.23% on October 5. Growing optimism about the US economy, and trade agreements between the US and Mexico/Canada has helped fuel the latest surge. Still, we have been here before. Five months ago, the 10-year yield breached the 3% level, before retreating below 2.8%. So, will the 10-year yield be able to sustain itself at these higher levels for longer this time round?
We think there is a good chance that it will. For much of 2018, low Treasury yields had not appropriately reflected the robust economic data in the US. The US has added 12 million jobs since the last economic peak in 2007, while the economy in the second quarter expanded at a rapid 4.2% clip thanks partly to the stimulative effects of tax cuts. Not only is the Federal Reserve reducing its $4 trillion portfolio of government bonds and mortgage-backed securities, but the Treasury is rapidly increasing supply of new bonds to fund a widening deficit. All of these forces can contribute to higher Treasury yields. As such, with the absence of any sizeable market shocks, we see the potential for the US 10-year yield’s range to extend higher to around 3.75%. Previously, we saw 3.25% as the likely top of the range.
However, headwinds to higher long-term US rates remain. The deterioration of the US-China trade dispute is an obvious factor. If tariffs on exports escalate even further, economic growth may suffer and investor would likely become more pessimistic. That could persuade more buying of Treasuries as these investors become more risk-averse. And, even though the Fed is shrinking its bond holdings, there are other ready buyers around. For example, US banks are nowadays required to hold more high quality, liquid assets on their balance sheet than they were before the Global Financial Crisis of a decade ago.
Yield differentials are also still meaningful. Compared to many other long-dated government fixed income assets around the world, 10-year US Treasuries do offer value. The premium over non-US sovereigns is now at multi-year highs. The 10-year yield is also at a multi-year high after taking inflation into account. The real yield is now above 1% for the first time since 2011 (Fig. 1). Therefore, we believe there are still good reasons why foreign buyers may look to US dollar debt, in addition to Treasuries’ status as the deepest, safest and most liquid traded asset in the world.
For now, we believe that the US 10-year yield may well push higher. That said, with the yield difference between 2-year and 10-year Treasury yields at a meager 30bp, we retain a neutral tactical weighting on long-duration debt. However, if stronger US growth and fading risk aversion pushes the US yield curve steeper and long rates towards the high end of our range, we may be inclined to change our position to overweight.
Figure 1. 10-year US real yields (using Treasury Inflation Protected Securities)
Source: Bloomberg as of October 12, 2018.
Past performance is no guarantee of future events. Real results may vary.