Treasury yields should fall as Fed cuts further

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The 10-year US Treasury yield rose last week by the most since April, despite market confidence in an interest rate cut at the Federal Reserve’s policy meeting this week. At 4.14% as of Friday's close, the 10-year yield was up 12 basis points over the week.

But we maintain the view that government bond yields will move lower, and we forecast the yield on 10-year Treasuries to fall to 3.75% over the next six months. With returns coming from a mix of yield and capital appreciation, we continue to see value in holding quality fixed income in a portfolio.

Latest data clear the way for further Fed cuts. September’s personal consumption expenditures (PCE)—the Fed’s preferred gauge of inflation—showed the annual core rate slowed to 2.8% from 2.9% the previous month. While this remains above the US central bank’s 2% target, the latest inflation data suggest that price pressures are not intensifying, with the monthly figure holding steady at 0.2% for three consecutive months. Combined with recent labor market data, which include a sharp drop in private payrolls and continued contraction in the ISM services employment index, we believe additional Fed easing is in store.

The US government is likely to manage the cost of government borrowing through further financial repression. Both the US administration and the Fed have an interest in keeping yields contained given rising debt and large fiscal deficits. In our view, financial repression mechanisms like bank, pension, and insurance rules, as well as central bank purchases, could be used to keep rates under control. For example, the US Treasury is addressing long-end rate pressures by shifting debt issuance to the short end of the yield curve and increasing buybacks of longer-dated bonds. Additionally, the Fed’s proposal to lower supplementary leverage ratio (SLR) requirements could unlock USD 200-500bn in bank capital for absorbing Treasury issuance.

Expected returns for medium-duration quality bonds are attractive. With yields still elevated and likely to fall, we believe quality fixed income offers an appealing combination of income and potential to perform well in the event of slowing economic activity and if rates are cut further. In fact, our estimated mid-single-digit returns for medium-duration quality bonds (four to seven years) in the coming year should exceed cash rates, making them a valuable source of portfolio income. Their potential to help dampen portfolio volatility is also critical in navigating the markets ahead.

So, with upcoming Fed cuts providing a favorable backdrop, we continue to see an important role for high grade government and investment grade corporate bonds in portfolios. Income-based investors can also consider opportunities in equity strategies, including both dividends and options strategies.