How much higher/lower could U.S. Treasury yields go?

Given current valuations and the economic outlook, lengthening duration remains an appropriate strategy going into 2024, in our view.

Since the regional U.S. banking crisis in 2Q 2023, the 10-Year UST yield has soared from a bottom of 3.4% year-to-date to around 5% in early November, reaching multi-year highs. It is important to differentiate between rising yields that reflect a stronger economy and rising yields that are driven by higher term risk premium (TRP), where investors are demanding more return to invest in the long end of the yield curve due to increased risks and uncertainties.

Firmer-than-expected economic data drove the rise in yields over the summer, as market participants priced in a higher-for-longer interest rate environment amid evidence of a stronger economy. More recently, however, the rise in yields reflects a higher TRP, which is broadly driven by demand-supply dynamics for duration. Markets are currently bracing for a deluge of UST supply to fund the government’s deficit. Meanwhile, the uncertain path of future inflation and interest rates has prompted investors to demand higher compensation in the form of higher yields.

Given current valuations and the economic outlook, lengthening duration remains an appropriate strategy going into 2024, in our view. Over the last five hiking cycles, 10Y UST yields had peaked before the fed funds rate. Between the last rate hike and first rate cut, 10Y UST yields also fell 107 basis points (bps). With disinflation gaining momentum and financial conditions becoming tighter (partly driven reflexively by the rise in yields), we are near, if not already at, the end of the Fed’s hiking cycle, limiting the upside in yields. Also, our base case of slower growth calls for lower yields, while potential flare-ups in geopolitical risks could prompt a flight to safety into UST.

While the direction of travel is likely to be downwards from current levels, we are less optimistic about the magnitude and speed of the potential decline in yields relative to past cycles. This is in part due to higher TRP being priced into yields for the long run, and in part due to lingering risks of longer-than-expected Fed tightening, driven by energy-related price pressures.

On credit, we acknowledge that current yields may look relatively attractive, especially in high yield fixed income. Looking at fundamentals, such as margins, coverage ratios and free cash flow, high yield bond issuers are exhibiting greater resilience than in past cycles. Default rates had reached 6.4% in October 2020, largely weeding out the weakest issuers from the market, while prompting surviving corporates to manage their balance sheets more conservatively. While fundamentals have not deteriorated significantly, the softer macroeconomic outlook could put this to the test. With current spreads consistent with robust economic growth, the risk is for spreads to widen with weaker economic data.

Exhibit 3:

Source: FactSet, U.S. Federal Reserve, J.P. Morgan Asset Management. Based on MSCI AC World Index (AC World), MSCI World Index (DM Equity), MSCI Emerging Markets Index (EM Equity), MSCI Asia Pacific ex-Japan Index (AxJ Equity), MSCI Asia Pacific ex-Japan High Dividend Yield Index (AxJ Equity High Div. Equity), MSCI World Growth Index (DM Growth), MSCI World Value Index (DM Value), S&P 500 Index (U.S. Large Cap), Russell 2000 Index (U.S. Small Cap), MSCI Europe Index (Europe Equity), MSCI Japan Index (Japan Equity), Bloomberg Global Aggregate (Global Bonds), Bloomberg U.S. Treasury Bellwethers 10Y (U.S. 10Y Treasury), Bloomberg U.S. Corporate Investment Grade Index (U.S. IG), Bloomberg U.S. Credit Corporate High Yield (U.S. HY), J.P. Morgan EMBI Global (EM Debt USD), Bloomberg U.S. Treasury Bills 1-3M (Cash), Gold New Spot price (Gold), U.S. dollar index (U.S. dollar), 60% AC World and 40% Global Bonds (60/40 portfolio). *Total returns in local currency are used, unless otherwise specified. **Refers to the duration between the last rate hike and the first rate cut, specifically Feb '89 - Jun ‘89, Feb '95 - Jul ‘ 95, May '00 - Jan ‘01, Jun '06 - Sep ‘07, Dec '18 - Aug ‘19.
Guide to the Markets – Asia. Data reflect most recently available as of 30/09/23.

 

Should growth show signs of a meaningful slowdown, corporates could experience further margin squeeze and an increased need to refinance at higher borrowing costs. A spike in defaults could easily cause risk-off sentiment to ripple across the market, triggering a rapid widening of spreads. As a result, we continue to favor higher quality bonds, unless investors have the risk tolerance and investment horizon to ride out higher volatility as growth slows.