Headwinds for Treasuries unlikely to persist

The 10-year US Treasury has come under renewed pressure, bringing the yield close to the highest levels since late 2022. At 4.16%, the yield is up around 10 basis points since the start of August and by just over 30 basis points over the past three weeks, as of 14 August. This has been driven by both global and US developments, in our view. Upward pressure on yields globally came from the Bank of Japan’s decision to ease its yield-curve control policy earlier than expected. In the US, the Treasury Department announced an increase in bond issuance to around USD 1 trillion for both the third and fourth quarters of this year.

Investors have also been digesting the decision of rating agency Fitch to strip the US government of its top triple-A credit score. But despite these headwinds, we see renewed upside for quality bonds, which compares favorably to our more cautious outlook for stocks overall.

• The safe-haven appeal of US government bonds remains intact, despite rising debt and the Fitch downgrade. The rating agency raised some legitimate concerns about increased US government debt—which it expects to reach 118% of national income by 2025 versus a median of around 39% for other triple-A rated nations. Periodic bouts of partisan brinkmanship over the debt ceiling also add to risks for investors. US Treasuries were not noticeably harmed by the S&P rating cut in 2011, and we expect a similar outcome this time. US Treasury Secretary Janet Yellen observed that the decision from Fitch would “not change what Americans, investors, and people all around the world already know: That Treasury securities remain the world’s pre-eminent safe and liquid asset, and that the American economy is fundamentally strong.”
• Yields look attractive and the monetary policy backdrop is supportive. US government bond yields have risen in recent weeks and months as the US economy has proved more resilient than expected. We think this provides a good opportunity for investors to put their excess cash to work by locking in attractive yields as the Federal Reserve nears the end of its rate hiking cycle. The more defensive, higher-quality segments of fixed income also offer the potential for capital appreciation as investors shift their focus from inflation risks to moderating growth. We expect the yield on the 10-year Treasury to decline from its current level 4.16% to around 3.25% at the end of the year.
• Broad equity indexes are already pricing plenty of good economic news. Even after a few modestly negative weeks, US stocks appear to reflect confidence among investors that a soft landing has actually occurred. That followed data pointing to a combination of solid growth—with GDP expanding by an annualized 2.4% in the second quarter—along with moderating inflation. In the first three months of the year, the employment cost index, the broadest gauge of wage inflation, fell to its lowest level since the second quarter of 2021. The MSCI US index trades at close to 20 times 12-month forward earnings, a 24% premium to the 15-year average. In addition, while the economic prospects have brightened, the soft landing the markets are pricing is not yet assured. Risks remain both of a renewed acceleration in inflation—given continued strong average hourly earnings growth in July and the recent rise in the oil price—or of a swifter deceleration of growth if the Fed has misjudged the lagged effect of prior rate hikes.

So, against this backdrop, we expect high grade (government), investment grade, and sustainable debt to deliver good returns over the balance of the year, and we prefer five- to 10-year maturities. In equities, we advise investors to focus on parts of the market that have so far lagged the rally, including value stocks and emerging markets.