Macro: Sandcastle economics
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FOMC and PCE data: US Treasuries are positioned for a short-lived rally
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The US yield curve is likely to bull steepen this week as the market expects the Federal Reserve to hike rates for the last time and inflation to subside in June. Two-year Treasury yields will find strong support at 4.58%, and ten-year yields at 3.7%. However, a significant change in sentiment needs to occur for yields to break below these levels as they remain in a bullish trend. This week's bond rally might be in peril by next week's Treasury refunding announcement, where Treasury auction sizes might increase, putting upward pressure on yields. We continue to prefer short-term and high-quality bonds, paying a sizable coupon.
This is not the beginning of a bond bull market
This week, a bull steepening of the US yield curve is likely as the Federal Reserve is expected to hike rates for the last time, ending the most aggressive interest rate hiking cycle in forty years.
However, it may be premature for a bond bull market to begin.
Despite recent encouraging inflation data, it’s important to remember that economists are forecasting core PCE to end the year at 4.2% and to end 2024 at 2.7%[1], well above the Fed’s inflation target. Therefore, without a recession on the horizon and another year and a half above-target inflation, there is little chance for the Fed to turn dovish anytime soon, limiting the bull steepening trend and the drop in yields.
What follows is a “passive tightening” of monetary policies. The concept is that as interest rates are kept higher for longer, they will contribute to a gradual and constant correction of price pressures.
In the meantime, an increase in coupon supply and a passive quantitative tightening (QT) are likely to keep yields high, too. The Treasury will release its refunding announcement on August the 2nd, and it can weigh on US Treasuries’ performance.
FOMC meeting and PCE deflator to contribute to a bull steepening of the yield curve
Friday's PCE deflator might have a bigger impact than Wednesday's FOMC meeting. The monthly PCE core deflator is expected at 0.2%, showing that tighter monetary policies are working against inflation.
Two-year yields are likely to find strong support at 4.58%. If they break below this level, they might drop to 4.25%. However, a major change in sentiment must occur to take yields that low as they remain bullish with a gold cross forming.
Similarly, ten-year yields remain in an uptrend. If they break below their 50 days moving average, they will find strong support on the 200 days moving average at 3.70%.
Overall, we expect a bull steepening of the yield curve to be a short-term phenomenon, with the 2s10s spread unlikely to break above -80bps.
Is it a good moment to buy US Treasuries?
As we approach the end of the cycle, US Treasuries offer good returns and lower risk compared to other assets. Ten-year yields still offer one of the highest yields since the 2008 global financial crisis. Similarly, two-year yields provide one of the highest yields since 2007.
Let’s give a practical example.
Let’s calculate US Treasuries' total performance considering both capital and income gains resulting from holding these securities until the end of this and the next year. In order to do that we assume that economists’ weighted average yield forecasts[1] are realized.
If held until the end of this year, 30-year US Treasuries will return more than double holding 2-year Treasuries. If the same securities are held until the end of 2024, their performance will be comparable.
Yet, if the risks of a recession materialize, long-term US Treasuries will have a more significant upside potential due to their high duration.
The caveat is, what if bond yields do not fall at the abovementioned pace?
It's best to keep duration at a minimum while benefiting from the highest coupon available. For example, the benchmark two-year US Treasury note (US91282CHL81) is now paying a coupon of 4.625%.
Corporate bonds: quality shines over junk.
We continue to prefer investment-grade corporate bonds over high-yield peers as with the prospect of higher rates for longer, credit risk is likely to increase, putting pressure on credit spreads of cash-strapped businesses. Although refinancing is unlikely to be a problem as many corporations restructured their debt after the Covid pandemic, raising debt to finance ongoing operations might be more problematic for lower-rated companies. Therefore, the pick-up that high-yield bonds provide over investment-grade peers is too small.
Below is a short list of investment-grade and high-yield corporate bonds with maturity between two and five years. While it’s possible to comfortably secure a yield of 6% in short-term high-grade companies, higher-rated junk bonds offer, on average, a pick-up of just 100bps over their investment-grade peers.
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