Reasons why we are bullish on rates

US Treasuries initially rallied, with 10-year yields dropping 5 basis points after the US nonfarm payrolls report for August suggested further jobs market cooling. But gains proved short-lived, and yields moved higher after the ISM manufacturing index for August came in above expectations at 47.6 (versus a consensus forecast of 47). On the day, US 10-year yields closed 7 basis points higher.

Recent volatility in US rates has raised the question of whether we are on the verge of a bear market for bonds. We do not share this view and think nominal yields will fall over our six- to 12-month forecast horizon for a number of reasons:

• First, monetary policy is restrictive. We gauge the monetary policy stance by looking at real rates and broader financial conditions. Real rates are now positive across the US curve, at levels not seen since the 2008 financial crisis. Mortgage and credit card rates are similarly at multi decade highs; lending standards continue to tighten, and the US manufacturing sector is already in a recession. Against this backdrop and considering the long and variable lags of monetary policy transmission, we expect US growth to slow down into early 2024.
• Second, inflation is falling and will continue to do so, albeit slowly, in our view. With demand rotating away from goods and into services and global supply pressures easing, PCE goods inflation was minus 0.5% year-over-year in July. Housing inflation has peaked and should continue to fall. Market rents inflation has been falling steadily since the Federal Reserve started tightening policy in early 2022 and is now back to levels close to its pre-pandemic average. But this will only be reflected in the official housing inflation gauge with a lag. Core services inflation ex-housing (super-core inflation) has been tightly linked to labor market tightness (e.g., openings/unemployed ratio, quits ratio) since the pandemic. US labor markets are now cooling in response to monetary tightening, if at a slow pace.
• Third, the recent bear steepening of the US Treasury curve is cyclical and local to the US. The move has been driven by a repricing of policy rate expectations for next year on the back of upside surprises in growth data and some widening of the term premium following the Fitch downgrade of US government debt. But we do not believe the US Treasury market has lost its safe-haven appeal, and it will likely continue to attract capital. There has also not been a material repricing higher of terminal policy rate expectations, indicating the market believes the Fed is close to the end of hikes. The widening of the fiscal deficit is often a signal of a slowing economy and historically has often resulted in lower—not higher—yields.
• Finally, we attach little weight to the view that the recent recalibration of the Bank of Japan's (BoJ) yield-curve control was the beginning of a larger move higher in global term rates. The move in the 10-year Japanese government bond yield since the announcement is less than 20bps and we believe the BoJ places much weight on financial stability, so any policy adjustments are likely to be done in a controlled fashion.

So, in our view, today’s high bond yields provide investors with a good opportunity to lock in currently elevated rates for an extended period. In fixed income, we like opportunities in the 5–10-year duration segment in high grade (government), investment grade (including select senior financial debt), and sustainable bonds.