Despite near-term headwinds for stocks, we’re at a rare time when in our base case, we expect cash, bonds, stocks, and alternatives to all deliver reasonable returns over the next six to 12 months and the longer term. (UBS)

First, the move has not been driven by rising inflation expectations; 10-year US breakeven inflation rates have remained relatively stable in recent weeks and are currently trading at 2.35%, consistent with the Fed hitting its target. Instead, the rise in yields appears largely due to technical forces operating at the long and ultra-long end of the curve. Notably, the Fed’s shift from quantitative easing to quantitative tightening has removed a significant source of buying, while issuance is trending higher with the increasing US budget deficit.

However, if this trend were to persist, we would expect action from the Fed to preserve financial stability by ensuring the proper functioning of the Treasury market. The Fed did this as recently as March by rolling out new lending facilities to provide liquidity following the collapse of Silicon Valley Bank.

Ultimately, we expect economic trends to return to the fore, pushing yields lower. US economic data continues to send mixed signals: The ISM survey for September pointed to a pickup in activity, while higher borrowing costs have been slowing housing transactions. Investors will now turn their attention to the employment data for September, which is released on Friday. But regardless of whether the landing is ultimately hard or soft, we think US and global economic activity will slow and inflation will moderate over the next year, boosting demand for high-quality bonds.

How do we invest?

Uncertainty around the outlook for Fed policy is likely to weigh on equity markets for now. With near-term risks elevated for broader markets, we are neutral on equities and favor adding exposure mostly to parts of the market that have lagged so far in 2023, including the equal-weighted S&P 500, value, and emerging markets.

Against the current backdrop, we see a better risk-reward profile for fixed income, and we recommend investors consider buying high-quality bonds in the 5–10-year maturity range. We foresee further cooling in inflation and slower global growth. Our 12-month forecast for the 10-year US Treasury yield is 3.5% in a base case, 4% in an upside scenario, and 2.75% in a downside scenario, which includes a US recession.

We also believe this is an opportune moment to add to diversified balanced portfolios. Despite near-term headwinds for stocks, we’re at a rare time when, in our base case, we expect cash, bonds, stocks, and alternatives to all deliver reasonable returns over the next six to 12 months and the longer term. In our view, investors can tap into an attractive opportunity set across asset classes, position for durable returns for years to come, and mitigate the effect of potential risks.

House in disorder

Kevin McCarthy was ousted from his US House Speaker leadership role in a 216–210 vote on Tuesday, with Republican dissidents taking action to depose McCarthy following his compromise continuing resolution (CR) with Democrats to avoid a government shutdown. McCarthy has indicated he won’t run for the speakership again, with a new vote on replacement candidates expected around 11 October. Last January, the House Speaker leadership vote that first elevated McCarthy was a protracted affair, with 15 ballots before he won sufficient support.

Our view: Absent a new House speaker, no action can be taken on bills, from routine matters to the funding of the federal government.The removal of McCarthy throws a wrench into the timing of budget negotiations as the Republican side of the aisle will need to focus first on leadership elections. Policy differences regarding border protection and military assistance to Ukraine remain persistent policy obstacles. We believe the ouster of McCarthy increases the probability of further delays in reaching a bipartisan compromise with the Senate over these and other issues, and increases the risk of a government shutdown in late November. A combination of robust US economic data and safe-haven inflows could extend US dollar strength in the near term, before an anticipated retreat next year.

Main contributors: Solita Marcelli, Mark Haefele, Jennifer Stahmer, Christopher Swann, Vincent Heaney, Matthew Carter, Alison Parums

For more, read the original report: Markets undermined by rate worries, 4 October 2023.