Markets brief: Will bond yields top 5%?
Even with a slowing economy next year, investors should expect higher rates.
Mentioned: Platinum International Fund (4505), Australian Foundation Investment Co Ltd (AFI), Commonwealth Bank of Australia (CBA), Vanguard Australian Shares ETF (VAS), S&P/ASX All Ordinaries PR (XAO)
Friday’s shocker of a US jobs report sent long-term bond yields briefly surging, and the strength of the economy has investors recalibrating the near-term outlook for interest rates.
While news of the big jump in hiring in September didn’t change near-term expectations for Federal Reserve policy (thanks in large part to the softening of wage gains, which eases inflation concerns), it hammered home the new reality for higher bond yields, at least for now.
For the decade and a half since the global financial crisis, the yield on the U.S. Treasury 10-year note—the benchmark for most mortgages—held between 1.5% and 3.0%. Some market observers now say bond yields are potentially in a range with the upper bound of 5%. At the lower end of the range, somewhere between 3% and 4% is deemed likely, barring a severe recession.
Before Friday, the yield on the U.S. Treasury 10-year note had already risen to 4.70% from 3.97% at the end of July. Following the release of the jobs data, the 10-year yield briefly jumped to around 4.85% before settling to end the day at 4.78%. These are the highest yields since June 2007.
“The bond market has been a one-way train,” says Tony Rodriguez, head of fixed-income strategy at Nuveen. Sentiment has turned solidly bearish, thanks to the unexpectedly strong economy and the increased amount of debt the federal government must sell to fund the deficit. “It’s a little bit difficult to stand in front of that.”
This may make yields on safe government bonds even more attractive. But when it comes to the outlook for the stock market, the question of how much higher bond yields will go (and further out, how much they could eventually fall) adds uncertainty.
Next up for the bond market will be the September Consumer Price Index report, due Thursday. Economists are expecting the report to show a moderation in inflation, but market watchers say bonds could be hit hard by any bad news.
On Friday, the Bureau of Labor Statistics reported that the U.S. economy added 336,000 jobs in September. That increase was more than double the new jobs economists predicted for the month. In addition, the BLS revised upward its previous estimates for new job creation in August and July.
The saving grace for the bond market was that under the hood, the September report may not have been as gangbusters as the headline increase suggested. In particular, economists pointed to a slowing of wage growth, which suggests the strong labor market isn’t translating into a wage-price spiral (which would feed a renewed upward push in inflation).
Matt Bush, U.S. economist at Guggenheim Investments, notes that the big job gains have been concentrated in a few sectors, mainly government, healthcare, and leisure and hospitality. “Looking at some of the underlying details, like whether it’s wage growth cooling down ... takes some of the hotness out of the initial report,” he says.
In addition, Bush says, “I don’t think today gives us a ton of new information about [the interest-rate environment] six months or a year from now ... For us, [the strong jobs market] is really reflecting tailwinds for the economy that we don’t think are going to last.
Bush says Guggenheim expects the effects of the pandemic-driven fiscal stimulus to fade because of factors like the resumption of student loan payments, and that the economy will slip into a mild recession in 2024.
Still, he cautions that investors shouldn’t expect a return to the kind of bond market seen prior to 2022. When it comes to yields, “we’re not going back to the lows or even really the averages of the last cycle,” he says.
One big reason is fiscal policy, as the swelling federal deficit is leading to heavier new issuance of government bonds. In addition, “what we’ve learned from this [Fed] hiking cycle is the economy is more resilient to higher interest rates than really anybody expected, including the Fed,” Bush says. He believes this means the so-called neutral rate (where the federal-funds rate neither restrains nor stimulates economic activity) is higher than had been assumed.
“In the longer term, that means higher equilibrium rates across the curve,” says Bush. “So we don’t see rates dropping below 3% for 10-year Treasury yields, even in a recession.”
At the upper end of the range, many in the markets are eyeing the 5% level on the 10-year note. Those round numbers are psychological markers, and traders will often place bets around breaking or holding those levels. Given the economic environment and Treasury auction supply, “there’s pressure to trade over 5%,” says Thanos Bardas, global co-head of investment-grade fixed income at Neuberger Berman.
In addition, a critical difference between the current bond market environment and the pre-2022 landscape is that the Fed and other major central banks are no longer buying up huge amounts of government debt to help stimulate the economy. The Fed is doing the reverse, letting its massive holdings of government bonds (still roughly $8 trillion) roll off.
When the Fed was buying bonds, it was essentially price-agnostic. But investors in a free market want yields on bonds that will compensate them for the chief risk of owning fixed income: inflation. That translates into positive real yields—the yield adjusted for expected inflation rates.
“As an investor, historically you bought bonds with the real yield in the range of 2.0%–2.5%,” says Bardas. Combine that with the Fed suggesting relatively small interest rate cuts next year, and he believes 10-year yields could gravitate toward a range of 4%–5%. “Near term, you can easily go above 5%,” he says, adding, “It’s just a number.”
Rodriguez has a similar outlook, couching it against the backdrop of an expected slowing of the economy in 2024. “If we’re right about this moderation of growth as a result of the lagged effect of this much higher rate environment that we’re in, we think that you will see lower rates by the middle of next year,” he says.
“We think it’s quite likely that you’ll see a 10-year that’s closer to 4%, and maybe slightly below that,” Rodriguez says. “Now, whether the 10-year hits 5% here is anybody’s guess. Certainly, the momentum is in that direction. And if you get a surprisingly high inflation print next week, it wouldn’t surprise us at all to see us get another 10-basis-point day—which seems to be routine nowadays—and all of a sudden, you’re knocking on the door of 5%.”
That said, Rodriguez adds, “We would say that we think bonds are attractive here and that over a six-to-12-month horizon … you will also end up seeing some price appreciation from a decline in yields.”
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