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The author is global head of fixed income research at HSBC, based in Hong Kong
There are three supporting arguments for the troubled US Treasury market: slowing momentum, value recovery and opportunity cost. These apply regardless of your longer-term fundamental assessment of interest rates and returns.
First, the momentum of the bond bear market is slowly coming to a halt. We can see this in the shift in the monetary policy sensitivity of the three-month US Treasury bill. After starting January 2022 at a near-zero yield, the yield followed the Federal Reserve’s hawkish turn and rose at a pace not seen in four decades. After reaching 1.67 percent in the first six months of 2022, it accelerated to 4.50 percent by the end of the year.
There was a dramatic slowdown in 2023. The additional percentage point over the 5.50 percent achieved in the first week of September compares to the 4.50 percentage point increase last year. In the language of monetary policy, the peak of the restrictive stance was more than a year ago. The overwhelming consensus among forecasters is that there will be no rate hike at the September 20 meeting, and based on the futures market, many believe there will be no further rate hikes from the Fed this cycle.
The challenge for policymakers now is to stop the market from overextending itself and preparing for rate cuts. The Fed is well served by the “higher for longer” mantra, at least for now, because it is still waiting for the delayed effect of the interest rate hikes. Policymakers call this “forward guidance.” Markets know that events or data will decide.
Second, attractive valuations are enough to make bond investors sweat. The absolute value is shown by the real interest rate for 10-year government bonds after taking inflation into account, which at just under 2.0 percent is above the trend in real GDP, which the Fed forecasts at 1.85 percent. Not only is this unusual, but it also means investors can diversify away from the stock market and into bonds, which traditionally carry less risk.
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Of course, this only applies if the economic growth trend itself is revised upwards, justifying a further increase in the real interest rate. We doubt it. Much of the recent growth has been due to fiscal generosity, and the impact of rising debt levels will weigh on future growth through the cost of servicing the debt level.
Relative valuations of government bonds compared to other G7 sovereign bonds also look tempting, a measure of how far Fed policy has ventured into restrictive territory compared to other central banks. And it is the riskier areas of fixed income, credit and emerging market local interest rates that have performed well this year. If another turn in the US interest rate cycle assumes they will continue to hold, then it is certainly better to hold the bonds that stand to benefit the most, namely US Treasuries.
Third, there is the opportunity cost for those investors recovering from this bear market who are currently stuck in a bed of Treasury bills – shorter-term government bonds that pay interest at maturity. Investors might ask themselves why take the risk of owning a 10-year security that currently yields about 1 percent less than a Treasury bill? The intuitive view based on the return difference ignores the opportunity cost – the potential foregone benefit of not choosing the other option.
Bonds offer the same fixed coupon over their term and therefore have a so-called longer duration – their price is more sensitive to future interest rate decisions. Bills of exchange have a minimal maturity but a high reinvestment risk as we do not know today what the offered return will be at maturity.
An example comparing a 10-year bond with a yield of 4.25 percent to a note with a yield of 5.25 percent demonstrates this. If the bond’s yield were to fall by just 0.125 percentage points, the price gain – combined with the coupon – would mean the yield equals the higher yield in the calculation.
Admittedly, bond prices can go up as well as down, so owning bonds presents a higher risk to the investor than owning bills. But for comparison: Since the beginning of 2022 – when the Fed became restrictive – the yield on 10-year Treasury bonds has risen by a whopping 2.66 percentage points. This corresponds to a price drop of the equivalent of 21 percent! However, if this trend turns into the opposite: with bond yields back to the levels seen last year in 2007, the opportunity cost of not switching from notes to bonds could be quite high if the trend reverses from 2022 onwards.
In summary, momentum and value favor bonds more today than they did a year ago, providing some comfort to investors considering the opportunity cost of switching from the safety of notes. You don’t have to be a long-term bull to buy bonds.
Source : www.ft.com