Importantly, the increase in rates does not appear to reflect higher inflation expectations, says CIO. (UBS)

Long-term interest rates are on the move

As a result of the strong September employment report out on Friday, 6 October, investors have changed their expectations for Fed rate cuts in 2024. The market is now pricing for the Fed funds rate to be 4.6% at the end of 2024, up from around 4% at the end of June. The Fed itself validated this view. The median participant at the September Federal Open Market Committee (FOMC) meeting expected a year-end 2024 funds rate of 5.1%, up from 4.6% at the June meeting.


But the higher-for-longer Fed funds rate expectation does not explain the entirety of the move. Other factors such as a rise in oil prices, quantitative tightening (QT), and a potential US credit rating downgrade due to government shutdown fears / dysfunction could all be playing a role. And particularly notable over the past few weeks has been the enormous imbalance of supply and demand in the market. The Treasury department has to simultaneously fund a deficit and refinance existing debt, resulting in USD 800bn of coupon issuance by year-end. The Fed is no longer buying these bonds with QT ongoing in the background. For the first time in decades, the US bond market seems to be waking up to this dynamic. As a result, the term premium—the compensation that investors demand due to the uncertainty about the outlook for longer-term interest rates—has, by some estimates, increased well over 50bps just in the past month.


The speed of the move in rates suggests that investor positioning may also be playing an important role. As mentioned, many investors were expecting rates to move lower this year. When that didn’t happen, they were caught off guard as rates rose and losses mounted. Consequently, the recent abrupt move higher in rates at least partly stems from the closing out of money-losing positions. Importantly, the increase in rates does not appear to reflect higher inflation expectations. The 10-year market-implied inflation expectation has barely budged from 2.2% at the end of June to 2.3% today.


In our view, while the move higher in rates looks overdone, investors appear side-lined as they’re unwilling to buy Treasuries because of the risk that yields continue to rise over the short term. We believe investors want to see clear evidence of economic slowdown to be confident that yields have peaked, a necessary condition for buyers to come back into the market en masse. We expect those conditions to be met in Q4. While US economic growth has been resilient, activity should slow as the labor market continues to cool, student loan repayments restart, and fiscal policy becomes less supportive.


In addition, inflation should continue to fall. The strong headline job growth in the September payrolls report might belie that forecast. But the continued moderation of average hourly earnings—which rose by only 0.2% m/m—and the 18-month trend of labor market cooling both suggest that growth and inflation should fall going into 2024.


What could break?
There is also likely a limit to how high rates can go before they start having a meaningful incremental drag on the economy, or cause something to “break” in the financial system. The job growth in September and most Q3 GDP tracking estimates hovering around 3% don’t indicate any real economic breakage yet. But a 10-year Treasury yield over 5% for a sustained period will create exponentially greater headwinds to growth. Yields at those levels should be above nominal GDP growth in Q4 and beyond, meaning the nominal cost of capital for even the safest borrowers will be well above nominal income and earnings growth. That is not sustainable for an extended period.


For instance, when looking through 2026, roughly 25% of the high-yield (HY) bond market needs to be refinanced. We calculate that the average coupon on HY debt coming due between now and the end of 2026 is 6.26%, compared with the current yield in the HY market of close to 9%. If rates stay high for an extended period of time, modest cracks in the HY market could become full-blown breakages that weigh significantly on the economy. The good news is that HY companies entered this year with the strongest credit metrics since 2011. While deterioration is likely, we believe that fundamentals should remain resilient for most HY companies over the next few years, outside of select CCCs.


Impact on stocks
The situation today is very different from 2022 when higher rates weighed heavily on stocks because the Fed was behind the curve, inflation was way too high, and expectations for the Fed’s terminal rate kept ratcheting up. Activity in housing is already fairly muted, so there is less scope for it to fall. Automobile demand has yet to recover to pre-pandemic levels, suggesting there is still meaningful pent-up demand after a few years of under-supply. More broadly, it appears that the “goods recession” is long in the tooth. With inventories in good shape across a host of industries, there could even be a period of restocking in the months ahead that would be supportive for corporate profits. The recent rise in the dollar will be a modest headwind for profit growth, but we don't believe it will be anything near the magnitude in 2022. Overall, we think the S&P 500 profits recession is over and the third-quarter earnings season should confirm the return to profit growth.


Higher rates are a bit of a drag on equity valuations, but could be outweighed by the improving profit picture, which is getting an ongoing boost from surging investment in AI, infrastructure, semiconductor manufacturing, reshoring, as well as resilient consumer spending—due to a still healthy labor market. It’s also important to remember that these interest rates would likely only be sustained in a period of higher growth where the economy remains resilient—which should also flow into top-line revenue growth.


While it’s true that higher financing costs could impact earnings, it should take a long time for this to play out for the largest companies. The weighted average debt maturity for non-financial S&P 500 companies is over a decade. The impact will be felt more quickly in small- and mid-caps that have lower credit ratings and much shorter average maturities. This is part of the reason we’ve remained neutral in these areas despite more attractive valuations.


Overall, our view is that the risk/reward in equities is getting more attractive. Valuations have pulled back with the S&P 500 trading at a P/E of 17.5x versus 19.5x in the summer. In addition, sentiment has turned fairly cautious, which means there is now dry powder on the sidelines to propel stocks higher if our outlook for corporate profits is correct. It’s nearly impossible to pick the bottom in sell-offs, but in our soft landing base case, stocks could rise by about 10% in the coming quarters.


Main contributors: Solita Marcelli, David Lefkowitz, and Jason Draho


For more, read the full report Weekly—Regional View US: Rate shock 6 October 2023.