Why the climb in long yields isn't likely to last
Senior Portfolio Manager R.J. Gallo can think of seven reasons.
Federated Hermes Fixed Income has been as surprised as anyone by the past two months’ spike in Treasury yields—over 50 basis points in the 10-year yield since early June and 25 basis points this week alone. This market move occurred even after the most recent U.S. inflation data continued to decelerate because the U.S. economy posted stronger growth, labor markets remain tight, the Treasury announced greater borrowing needs, the Bank of Japan eased yield curve control and the market had been leaning long, increasing vulnerability to the recent swoon.
So, why do we think this dynamic won’t last? Here are seven reasons:
- Valuation Real and nominal yields are back at their highest levels since the global financial crisis. Yes, the post-pandemic economy has surprised on many fronts. But with inflation fading and growth apt to decelerate, market levels are attractive.
- Policy lags It has been just 16 months since the Fed first lifted its target rates in March 2022. The lags in policy effects vary across sectors, but many of this drastic hiking cycle’s impacts are still in the pipeline.
- Higher costs of capital Though spreads (the yield gap between other bonds and Treasuries) may have narrowed lately, the costs of capital across all segments of the fixed income spectrum have risen sharply. This effect will, over time, slow economic activity as maturing debt needs to be rolled over and new borrowers face higher costs.
- Bank stress Pressure in the banking system has eased from its most acute phase, but credit conditions (availability and price of credit) have tightened. In addition, the negative implications of falling office and retail property valuations have yet to fully unfold in the credit markets and the banking system.
- Fading consumer Consumer spending slowed in the most recent GDP release (advanced Q2) and should fade further as student loan payments resume and remaining excess savings diminishes.
- Weakening global growth Europe and China are each growing more slowly than the U.S. In fact, the ECB is becoming more cautious in its hiking amid the deteriorating economic momentum there. China faces significant structural challenges and seems unlikely to implement large offsetting stimulus.
- Asymmetry of risks Market pricing reflects the tug-of-war between a soft landing versus a recession in coming quarters, with the rope lately pulled in the soft-landing direction. Any weakness in jobs or other data should create a larger snap back in the opposite direction.
The price action over the past eight weeks has been painful, but we’re sticking to a modest long duration position in our fixed income portfolios in anticipation yields will decline in coming months. History shows when yields start to move the other way—and the seven reasons suggest they might—they often move quickly.