The case for bonds remains despite the recent rise in yields

Bond markets remain choppy. On Thursday, 10-year US Treasury yields reached 4.69%, a high for this cycle, before reversing course to close lower on the day. At the time of writing on Friday, yields had dipped further to 4.54%, but remain 45 basis points higher than at the end of August. In Europe, 10-year Bund yields rose 9 basis points on Thursday to 2.93%, their highest level since the 2011 Eurozone debt crisis, but pulled back to 2.87% on Friday morning.

Indications from both the Federal Reserve and the European Central Bank that rates are likely to stay higher for longer have prompted investors to push back the expected timing of eventual rate cuts, helping drive yields higher. But, we would also note the following about the most recent leg higher in yields:

• 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 2.38%. Similarly, in Europe, the yield moves have been driven by real rates with the 10-year German real yield closing at a post-2011 high of 0.50% on Thursday. One of reasons we think this week’s price action is technical is that most of the moves have been in the long and ultra-long end of the curve. At the front of the curve, rates have been relatively stable after last week’s Fed policy meeting. This is why we recommend the 5–10-year part of the curve, since this is less heavily influenced by technical factors like the 10-year and beyond part of the curve.
• In the US, increased Treasury supply appears to be causing temporary “indigestion” among bond buyers. 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 budget deficit. While a factor in recent bond market price declines, we expect the Fed’s focus on preserving financial stability would prompt it to take action if needed to ensure the proper functioning of the Treasury market. Earlier this year, after the collapse of Silicon Valley Bank, the Fed introduced new lending facilities to provide liquidity.
• Yield movements may have been exacerbated by shifts in positioning. With an end to the central bank tightening cycle nearing, fixed income markets moved to price in rate cuts in 2024. As a result, being long bonds ahead of an expected decline in yields next year as central banks loosened policy had become a consensus trade. Our view has been that markets had become overly confident in pricing a rapid easing of monetary policy from the Fed. In recent weeks, CFTC data has shown a reduction in long positioning, as investors have adjusted their exposure.

In our view, the move higher in yields has been amplified by these technical factors. Looking ahead, regardless of whether the landing is ultimately hard or soft, we think US and global economic activity is set to slow over the next year. Falling inflation should bolster the real return on fixed income, despite the recent rebound in energy prices. US yields remain well above long-term equilibrium levels, providing scope for them to fall as the macroeconomic outlook becomes more supportive for bonds.

In this environment, we retain our preference for high-quality bonds in the 5–10-year maturity range. Our base case is for the yield on 10-year US Treasuries to stand at 3.5% in 12 months, 4% in our upside scenario for growth, and 2.75% in our downside scenario of a recession. That would translate into total returns over the period of 14% in our base case, 10% in our upside economic scenario, and 20% in our downside scenario.