While the market prices less than a 5% chance of a rate hike in December, we believe the probability of a rate hike is higher, pending receipt of the remaining two inflation reports and one more payroll report. (UBS)

After 39 months of rising rates, the market is focused on whether higher-quality sectors will end 2023 in negative return territory for the third consecutive year. While that would be unprecedented, it is important to remember that we started this cycle with historically low yields—i.e., a 10-year yield that fell below 0.5%.


The negative sentiment prevalent in October, as long-end rates rose much faster than the short-end, kept investors sidelined. While marketable debt outstanding of USD 26.4 trillion (and climbing) cannot be ignored, we have argued that it is not the main driver of rising interest rates. Instead, better-than-expected economic data alongside the market repricing to the higher-for-longer Fed path was the ultimate driver.


While most market participants have been declaring the July interest rate hike the last of the cycle, US Treasury yields have not gotten the memo. Historically, when the Fed shifts policy from tightening to a pause, 10-year Treasury yields begin to trend lower. We believe the historical path will reoccur post-pause but the magnitude of the decline in yields 3–6 months after a policy shift may not be quite as large due to heavier supply and quantitative tightening.


So why hasn’t the market shifted to “pause mode?” Very simply, we may not be there yet. It is in Chair Jerome Powell’s best interest to leave the door open for another rate hike in December to ensure that the market does not overreact, loosen financial conditions, and partially undo the restrictive policy stance necessary to slow both the labor market and the economy.


While the market prices less than a 5% chance of a rate hike in December, we believe the probability of a rate hike is higher, pending receipt of the remaining two inflation reports and one more payroll report.


The possibility of one more rate hike will continue to be a headwind to a post-pause yield decline. With 2023 being the year of economic underestimation, fixed income now is a “show me” market. This was very apparent with the below-expectation print of the recent nonfarm payrolls data, which brought 10-year yields to 4.47%. The Treasury Department’s announcement of tamer borrowing needs, particularly in the back end of the yield curve, provided an assist but it was not the main driver of the yield decline—weaker data was.


We do believe we have seen the high in interest rates at 5.01% for 2023. However, barring a well above-consensus inflation report, we are not looking for a material decline into year-end until after the 13 December Fed meeting. While our 4Q23 growth expectation hovers around 2%—less than half the pace of the prior quarter’s 4.9%—we expect to remain between 4.5% and 5% on the 10-year yield until we see additional softer data and receive more of a verbal confirmation from Powell of a pause versus a “wait and see” posture.


If the Fed does signal a pause in December, we look for yields to end 2023 near 4.25% and stay in that range into the new year, trending lower during 2Q24 as the economy begins to slow and the Fed pivots to a new policy cycle that will likely last through 2025. Currently, the market is pricing in about 145bps of easing through 2025, with a long-term federal funds rate between 3.8% and 4.2%, substantially higher than the Fed’s longer-term neutral rate forecast of 2.5%. While we view 2.5% as too low in this new rate regime, we do believe that 4.2% is too high for a long-term forecast given the expected decline in inflation toward 2% in 2025. A 2.2% real fed funds rate (4.2% minus 2% inflation) may prove too restrictive, and we look for the fed funds rate to settle around 3.25–3.5% in 2025.


Therefore, while the next few months may remain choppy into year-end, the trend in interest rates will be lower. We have positioned our portfolios for lower yields, lower volatility, and diversified—but higher—credit risk exposure.


For more on the impact of rising volatility on fixed income and positioning, see the full report Fixed Income Strategist: Looking through the volatility 9 November 2023.


Watch the video UBS Trending: Possible fears of negative returns?