Deep Dive: Trading the US dollar (7:34)
CIO FX Strategist Teck Leng Tan on where to find relative value in currencies.

Thought of the day

What happened?

The S&P 500 Index closed 1.4% lower yesterday, taking the index to its lowest level since May 2023. Meanwhile, the tech-heavy Nasdaq—which is typically more vulnerable to higher rates—was down 1.9%. Within the fixed income markets, 10-year Treasury yields rose 12 basis points to 4.79%, and the 2-year Treasury yield gained 5 basis points to 5.15%. This move took yields back to highs of 16 and 17 years ago, respectively. The dollar, as measured by the DXY Index, which tracks the US currency against six major peers, strengthened. The DXY Index is now 7.3% higher than its mid-July low.

At the time of writing on Wednesday, the yield on 10-year Treasuries edged still higher, climbing to 4.82%, while S&P 500 futures were flat.

The rise in yields has accelerated since the Federal Open Market Committee's (FOMC) meeting in September, where the Summary of Economic Projections (SEP) report provided a dot plot of interest rate forecasts pointing to the potential for 50 basis points of easing in 2024. This was significantly lighter than the Committee's forecasts for 100 basis points of cuts in 2024, as published in the June 2023 SEP.

Concern that rates may stay higher for longer were intensified on Tuesday by the release of the Job Openings and Labor Turnover Survey (JOLTS) for August. This survey showed a 690,000 increase in job openings for the month to 9.61 million, while vacancies for July were also revised higher. Demand for personnel was particularly strong in professional and business services.

The Fed remains data dependent in deciding on its next rate move. While US economic data has been mixed of late, excessive demand for workers could encourage a final rate hike before the end of 2023 and make it harder for the Fed to justify rate cuts until well into 2024.

What do we think?

Recent developments support our view that markets had become overly confident in pricing a rapid easing of the Fed's monetary policy. While we expect equity and bond market conditions to improve, we forecast choppy and rangebound trading in equity markets in the near term, as well as a reverse in the recent rise in longer-duration yields.

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.