Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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US Treasuries: where do we go from here?
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The new year is going to be all about yield curve normalization. Although the road to a steeper yield curve will be bumpy due to geopolitical and monetary policy uncertainties, sovereign bonds remain compelling. A deflationary environment builds the case for a longer bond duration.
The new year is starting with one certainty: the normalization of the yield curve is underway.
The reason is simple: central banks' focus turns from inflation to growth. That means that as inflation reverts to its mean, central banks will claim victory over inflation and will be more concerned about a deteriorating economy. That will call for interest rate cuts, precisely as the Federal Reserve's December dot plot shows. Therefore, it is safe to expect font-end rates to adjust lower, resulting in a steeper curve.
The big question, however, is what will happen to the longer part of the yield curve as central banks cut rates. When answering this question, it’s impossible not to enter into a heated debate regarding some sort of landing:
- A “soft landing”: such a scenario implies that inflation reverts to its mean without a significant deceleration of the economy. In this case, the yield curve will bull steepen, but without a recession, the long part of the yield curve will remain around current levels or even move slightly higher.
- A “hard landing”: such a scenario implies a deep recession is upon us. That means the Federal Reserve might need to cut rates deeply and quickly. That would result in a steeper curve, with 10-year yields dropping sharply below 4%.
- A “’70s landing”: the fight against inflation is not over, and as geopolitical tensions intensify, inflation rebounds, resulting in a new inflation wave. Yet the economy stagnates, resulting in a flatter yield curve.
Although it's impossible to know which kind of landing we are headed towards, it's essential to recognize that the Fed can stimulate the economy through various policies beyond interest rate cuts, such as a slowdown or the early end of the Quantitative Tightening program (QT).
QT is a powerful tool because it can be a substitute for interest rate cuts. Therefore, if a “hard landing" doesn't materialize, bond futures must price out some of the six rate cuts that are baked in for this year.
Moreover, we must remember that the US Treasuries is poised to continue issuing large amounts of bonds and notes in the upcoming months, putting upward pressure on rates.
That means that if a recession is not around the corner and the economy continues to prove resilient, 10-year yields are more likely to move higher than lower in the upcoming weeks. That's probably why Bill Gross, in a recent tweet, says that "UST 10 yr at 4% is overvalued while 10 year TIP at 1.80 is the better choice. If you need to buy bonds. I don’t.” When looking at the market's expectations for interest rate cuts, 10-year yields at 4% do not make sense because investors expect rates to decrease to 3.5% in the next ten years. Considering that 10-year US Treasury offers between 100bps to 150bps over the Fed Fund rate from 2000 until today, their fair value should be around 4.5% to 5%. Yet, market expectations can change abruptly, especially during a downturn.
Therefore, we'll likely see ten-year US Treasury yields rising slightly and trade rangebound for some time until the macroeconomic backdrop becomes clearer.
Currently, 10-year yields 
are trading slightly above 4%. If they break above 4.1%, they might find a new trading range between 4.1%- 4.3% (see Kim Cramer Larsson's technical analysis piece).
Sovereign bonds remain attractive for long-term investors.
Even if yields rise in the medium term, sovereign bonds remain an attractive investment for buy-to-hold investors. Extending a portfolio duration is also compelling in light of deflationary trends and central bank's plans to cut rates.
Benchmark bonds issued during the last Treasury quarterly refunding offer a coupon that creates a buffer against a possible drop in price. The ten-year tenor looks particularly compelling. Assuming a one-year holding period, if yields rise by 100bps, the loss that one would expect is a little above 2%. As we learned last year, 5% is a strong resistance level for 10-year US Treasuries. If yields could not break above this level when it was uncertain whether the Federal Reserve was done with its interest rate hiking cycle, it is hard to envision they would even rise around this level now that central banks are preparing to cut rates on both sides of the Atlantic.
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