This pain should pass

The economy has posted resilient growth despite the Fed’s massive tightening, a fact that has been apparent for months. So, what is behind the most recent surge in yields, with the 10-year Treasury yield rising over 50 basis points in September? Big shifts in both the monetary policy outlook and in bond market sentiment. Market expectations of four rate cuts next year got a cold shower at this month’s Fed meeting. On the back of an economy that remains resilient—the Atlanta Fed’s running estimate of real growth has Q3 GDP tracking at 4.9%—the central bank signaled its intent to hold rates at higher levels for longer. The FOMC’s dot plot in fact suggested a possible quarter-point hike by December and just two cuts next year. Meanwhile, for this year and next, policymakers projected stronger GDP growth, less unemployment and ongoing disinflation. These soft-landing prospects weighed on Treasury market sentiment just as foreign demand for Treasuries faded, driving yields to new post-GFC highs and generating further liquidations by some nervous longs in the market.

While the Fed’s combination of more growth and ongoing disinflation reinforced the new market consensus for a soft landing, our fixed-income team has its doubts. We still expect a mild recession or at least significant growth deceleration to emerge either late this year or early 2024. As strong as the year has been, headwinds are building: rising oil and gas prices; a struggling Europe and China; continued bank stress (even if the worst has passed); and a consumer confronting the resumption of student loan payments, the exhaustion of accumulated excess savings, higher rates on credit cards, and an apparent downshift in the pace of job creation. The drama over a government shutdown does not help, weighing on consumer sentiment and placing a small drag on Q4 GDP, even if such events historically tend to produce little or no market reaction. A prolonged UAW strike could bite, too.

This outlook has us staying in a modest, tactical long duration position in our fixed income portfolios, scouring every data release for signs of emerging economic weakness that could push the 10-year Treasury yield lower, perhaps to 4.25% or 4.0% by year-end. That said, we understand that the post-pandemic economy may well produce higher equilibrium Treasury yields than prevailed between the GFC and the onset of the Covid crisis. Large U.S. federal deficits and the accompanying issuance to fund them, huge capital demands of a greener future, some rollback of globalization and a likely productivity boost from AI should contribute to higher equilibrium Treasury yields relative to the past 15 years. What is uncertain is where that equilibrium lies. Still, at this juncture, our expectations of a cyclical slowdown support a modest long duration position in expectation of some decline in Treasury yields from current levels.