Bond Update: Faster Disinflation Paves the Way for Imminent Rate Cuts, but Risks of Economic Reacceleration Remain

Summary:

• A faster-than-expected disinflationary trend paves the way for imminent interest rate cuts, increasing demand for duration.
• In the short term, bullish sentiment may drive ten-year yields down to 3.78% and thirty-year yields to 4%.
• In the long term, however, Treasuries remain vulnerable to an economic reacceleration as the Federal Reserve cuts rates, compounded by ongoing fiscal concerns. We estimate the fair value of 10-year U.S. Treasuries to be between 4.5% and 5%, and the 30-year yield to range between 5% and 5.5%.

June Consumer Price Index Decline Surprises, Exceeds Downside Estimates.

June's headline CPI numbers surprised on the downside, coming in at 3% YoY (vs. est. 3.1%) and core CPI falling to 3.3% YoY (vs. est. 3.4%). Notably, the monthly headline reading was -0.1%, marking the first negative reading since July 2022, and the biggest monthly drop since April 2020. While these numbers are welcomed by markets and policymakers, it's important to remember that the economy is not in a recession, and imminent interest rate cuts could potentially re-accelerate economic growth in the long term. For now, however, the market is likely to respond positively to the news, with yields potentially dropping to levels seen in December 2023.

Federal Reserve rate cut expectations and yield curve dynamics

Interest rate cut expectations by the end of the year increased from 50 basis points to 58 basis points following Thursday morning's CPI readings. The probability of a first cut being implemented in September also rose to 85%, compared to a 73% chance priced in a day earlier. In addition to being fueled by an accelerating disinflationary trend, this expectation is driven by the evident economic slowdown and the Federal Reserve's ongoing search for opportunities to reduce rates since December of last year. Federal Reserve Chair Jerome Powell's recent testimony to Congress indicates that while the Fed is not yet satisfied with the current level of inflation remaining around the 3% mark, policymakers may consider cutting rates before the Consumer Price Index (CPI) hits the central bank’s 2% target due to clear signs of softening in the labor market.

As the Federal Reserve begins to cut interest rates, we can anticipate a steepening of the yield curve, contributing to a decline in yields. While the front end of the yield curve adjusts to changes in monetary policy rates, the significant question remains whether a bond bull rally will materialize in the longer part of the yield curve.

In the short term, as the Federal Reserve cuts rates amid economic weakness and sustained disinflation, it is reasonable to expect increased demand for longer-duration bonds. However, given that the current economic weakness is concentrated in specific market segments, there is a possibility of a reacceleration of economic activity and potentially rising inflation. Consequently, the long end of the yield curve may adjust to a higher level than many currently anticipate.

Economic weakness in the U.S. stems from the poorest parts of society.

Recent data indicate that economic weakness in the U.S. is increasingly rooted in the lower strata of society. Unemployment rates are rising among Black and African American communities and individuals with less than a high school degree, with the latter's unemployment climbing from 7% in August 2023 to 7.8% today. Despite a high participation rate, wage growth for lower-wage workers has significantly declined from 7% to 4% year-over-year. The poverty rate remains at 11.5%, while the personal saving rate is low at 3.9%, comparable to pre-2008 levels. Debt levels for credit cards and auto loans have surged to their highest since 2010-2011, and fewer consumers are taking on new debt, likely due to economic uncertainty and higher interest rates. Housing affordability is worse than pre-GFC levels, with more people opting for rentals, highlighting broader accessibility issues. Overall, these indicators show that the poorest segments of society are bearing the brunt of economic challenges.

The same can be said when looking at corporate bond spreads. While, as a whole, investment grade and high yield corporate have been tightening since the beginning of the year, the most cash-strapped business have been suffering as defaults are quickly rising. While that contributed to a substantial widening of the credit spreads within the weakest part of the economy, it failed to spread to other parts of the economy resulting in a overall tighter average junk bond corporate spread.