November 2023, From the Field
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The number one question—in fact, maybe the only question—that clients are asking me at the moment is, “Did I miss the top in yields?” My answer is, probably not.
As readers of this blog will know, one of my highest-conviction views over the last few months has been for higher global government bond yields. This has come to fruition, but in the last couple of weeks we have seen a violent counter-trend rally.
The sell-off in longer-maturity rates began in, roughly, late summer and saw the 10-year U.S. Treasury yield briefly reach 5.00% in October. We saw this sell-off coming as a final “blow-off” move higher in yields—the phase three in the framework we defined in “The Four U.S. Treasury Yield Phases of a Fed Tightening Cycle.” Our internal discussions have centered on whether phase three has ended and whether we are moving into phase four—the transition to a rapid decrease in yields. Again, the answer is, probably not—we are likely still in phase three.
One argument against this and in favor of phase four is that in previous Federal Reserve (Fed) hiking cycles, yields tended to peak within four months on either side of the final rate increase. With the Fed’s most recent hike in late July currently looking like its last, the clock could already be ticking on yields peaking. Will history repeat itself? Or does the very different starting point in terms of yield curve shape, ongoing quantitative tightening, a large fiscal deficit, and volatile global geopolitics make the Fed’s signal less reliable this time?
For the short end of the yield curve, we would argue to continue to focus on the Fed. For the long end, other factors may be more important. Put simply, expect a steeper yield curve.
With that said, there is active debate among our portfolio managers about the indicators that we should look for when determining whether we’ve seen the peak in yields and are indeed in phase three. Some managers are waiting to add duration1 until the point where market pricing of the Fed’s rate path fully reflects the Fed’s projections—in mid‑November, federal funds futures showed that investors expected about four cuts of 25 basis points2 each in 2024, while the Fed’s latest forecast anticipated only two rate cuts.
(Fig. 1) Four yield phases in historical hiking cycles
As of October 31, 2023. Past results are not a reliable indicator of future results.
Source: Bloomberg Finance L.P. Please see Additional Disclosures page for information.
I favor waiting to add U.S. duration until at least one of the following four criteria are met, which I think indicates the transition to phase four—a meaningful rally in rates—is imminent.
I have been fully expecting some rallies that temporarily push yields lower as we wait for our indicators that we’ve reached a peak in rates to turn green. While these yield decreases could be meaningful and enticing, I anticipate waiting for one of these signposts to appear before strategically adding duration.
Also, I am convinced that yield curve segmentation will lead to most of the eventual rally in duration taking place at the shorter end of the yield curve. Given the recent tightening of financial conditions, growth is likely to slow, benefiting shorter maturities. But the flood of upcoming longer-term government debt supply will probably keep yields at the long end of the curve more elevated. So whether or not we have seen the peak in yields, yield curves will steepen over time in a move that could be led by either end of the curve.
1 Duration measures a bond’s sensitivity to changes in interest rates.
2 A basis point is 0.01 percentage point.
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The views contained herein are those of the authors as of November 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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