U.S. Treasury bond yields surge on strong data and increasing market expectations for additional Federal Reserve rate increases
October 4, 2018
U.S. Treasury bond yields surged yesterday and are rising again today. The 10-year U.S. Treasury yield rose above 3.2 percent on Wednesday before retracing slightly while the two-year hit 2.9 percent. Yesterday’s move was large but not unprecedented. On average, 10-year Treasury yields have experienced larger one-day moves one out of 25 trading days since 1962.
The primary catalysts for the surge appear to be strong economic data and comments from Federal Reserve (Fed) Chairman Jerome Powell. These events prompted investors to increase odds of additional Fed rate increases and upgrade the growth outlook, which, in turn, drove bond yields higher. First, the Institute for Supply Management (ISM) Services Index expressed broad economic growth in the third quarter. Second, ADP employment data indicated that the job market remains “red hot.” Finally, Fed Chairman Powell stated, “Very accommodative policy is no longer appropriate in the current environment . . . we may go past neutral [the level at which interest rates neither stimulate nor restrict economic growth], but we’re a long way from neutral at this point.”
Over the past two days, market odds for the number of Fed rate increases between now and year-end 2019 rose from two and one-half to three. This remains lower than the Fed’s median estimate of four rate hikes. We have long stated that the gap between market and Fed expectations must be reconciled, likely via higher market expectations (and bond yields).
We do not anticipate material negative spillover into stocks and credit markets
While rising borrowing costs may eventually inhibit economic growth and the prospects for stock and corporate credit markets, there are three reasons we do not see evidence for immediate concern.
- First, high yield and investment grade credit spreads (the yield difference between bonds with credit risk relative to U.S. Treasuries) were stable to tighter yesterday, showing no signs of stress.
- Second, three-quarters of the recent move in rates can be attributed to rising real yields, a proxy for growth expectations.
- Third, the slope of the yield curve (the difference between short-term and long-term bond yields) has steepened in recent weeks. An inverted yield curve is seen by many as a potential harbinger of a slowing economy and a steepening of the curve represents further evidence of an uptick in domestic growth expectations.
Global bond yields are also moving higher
Bond yields in the United States have moved higher on the basis of strong economic data supporting further increases in interest rates. Safe haven sovereign yields outside the United States have moved higher largely due to a spillover in growth expectations, though not to the extent of domestic yields. However, certain pockets of global bond markets are experiencing rising yields for idiosyncratic risk- based reasons. We remain cautious on non-U.S. fixed income.
We continue to expect modestly higher bond yields and recommend shortening portfolio duration
Our view remains unchanged and we continue to believe bond yields are likely to move modestly higher this year and into 2019, supported by continued gradual rate increases, strong growth, inflation near the Fed’s target and higher U.S. Treasury supply. We continue to believe the Fed will increase rates a fourth time in 2018 (at the December meeting) and their median 2019 estimate of three rate increases is a reasonable base case. As markets increasingly price in this likelihood, government bond yields are likely to rise. We continue to believe the risk/reward of Treasuries relative to investment grade corporate credit is balanced since the strong economy supports historically high credit valuations, for the time being. We continue to advocate for below-benchmark duration exposure due to our expectation for higher yields, combined with the flat curve, which creates minimal opportunity cost for remaining in shorter duration exposures.
Potential risks to our outlook
Domestic economic growth appears to be strong and, in our view, the United States remains “the best house in a global neighborhood.” However, risks remain, including trade negotiations that, to date, have been more newsworthy than market worthy but may yet escalate to levels that could result in a capital market response. In addition, moderating economic growth outside the United States could become a drag on strong U.S. growth. In this case, the Fed’s projected path of rate increases could be called into question.
As we enter into an event-filled fourth quarter, we will keep you informed of our views. Please do not hesitate to contact us for insights related to your unique circumstances or if we can be of assistance.
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