The bear-steepening trend of the yield curve remains intact spelling ongoing troubles for ultra-long maturities.

Medium-term inflation trends remain concerning.

On Friday, the University of Michigan's 5- to 10-year inflation expectations rose to 3.2%, the highest since the 2011 Arab Spring. Despite being merely a survey, it is considered one of the most important inflation expectation measures and market moving. It shows that despite the Federal Reserve has hiked rates aggressively, inflation expectations remain well anchored, and they might continue to feed through price pressures. If people expect prices to rise by 3.2%, businesses will look to raise prices by this amount, and workers will seek a comparable salary increase.

It's also key to recognize that the University of Michigan inflation expectations are not the only metrics showing that inflation might be sticky on the long run. The 5-year-5-year forward inflation swap forward rate has risen significantly since the beginning of the year, and it remains well above the 2% target.

As medium-term inflation expectations remain sticky, is unlikely that the Federal Reserve will change narrative, hence we can expect it to stick to the higher-for-longer narrative. If markets believe that a pivot is nearby, investors will position for interest rate cuts, causing a drop in yields across the yield curve and easing financial conditions. As long as inflation remains well above target and real growth well above 0%, it is unlikely that the central bank will want to ease the economy.

Today’s US CPI numbers will be a focus for bond markets. The headline CPI figures are expected to drop from 3.7% in September to 3.3% in October. However, the core CPI data are expected to remain at 4.1%, flat from September, showing a 0.3% MoM increase. That should be enough to keep markets on edge, exposing the long part of the yield curve to further selloff.

Moody’s U.S. rating outlook revision is not a game changer.

As a cherry on top of the cake, on Friday, Moody’s changed the outlook on the long-term rating of the United States from stable to negative. Moody's is the only rating agency leaving the country with Aaa, while S&P and Fitch have already downgraded it to AA+. The news didn't generate market volatility because investors had enough time to consider what a downgrade might mean for their portfolios this summer when Fitch downgraded the country to AA+ in August, making the U.S. a split-rated AA+ country. We have discovered that it doesn't matter if the country is rated AAA or AA+. Regardless of the rating, financial contracts refer to “AAA or debt backed by the U.S. Government”; hence, a downgrade wouldn’t provoke a forced unwind of repurchase agreements, loans, and derivatives.

Counterintuitively, a third and last downgrade to AA+ might provoke a rally in U.S. Treasuries. Indeed, if the United States is rated AA+, companies operating in the U.S. will need to be respectively re-rated. How can companies such as Microsoft and Johnson and Johnson have a better rating than U.S. Treasuries? Would these companies be more likely to repay their debt in a credit event than the U.S. Treasury?

Changes in corporate ratings might provoke volatility in credit markets, favoring U.S. Treasuries in the near term.

A bond barbell: a balanced strategy as the macroeconomic backdrop remains uncertain.

The yield curve will continue to steepen. The bear-steepening of the yield curve will likely continue until the year's end as the economy remains buoyant and the Federal Reserve stays on hold. A switch to a bull-steepen is likely next year as the U.S. Economy decelerates markedly and inflation expectations continue to drop.

Within this environment, a bond barbell strategy involving the front part of the yield curve up to 3-year and the ten-year tenor might prove advantageous. In the front part of the yield curve, it is almost impossible to lose money. Two-year U.S. Treasury pays 5% in yield, and this position will be in red only if yields rise by 200 basis points or more. Ten-year US Treasuries also offer an attractive risk-reward rating. Considering a one-year holding period, 10-year notes will provide a total return of -2.25% if yields rise by 100bps, but they will pay +12% if yields drop by 100bps, protecting in case of a recession or a credit tail event.

We remain defensive regarding duration and continue to dislike the ultra-long part of the yield curve. Another test will come next week when the Treasury sells 20-year notes.