USD Interest Rates Commentary

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Interest Rate Market Snapshot
  Federal Funds SOFR 2Y Treasury 5Y Treasury 7Y Treasury 10Y Treasury
  5.33% 5.30% 5.08% 4.81% 4.87% 4.85%
Source: Bloomberg 
Bond yields hit fresh multidecade highs 
  • It’s been a remarkable run up in bond yields these past few weeks

    • 2-Year yields traded flat today but at ~5.08% are near the highest point in roughly 17 years. And if the market gets just a whiff of hawkish Fed speak next week, another 20 basis point selloff will see those yields at 23 year highs
    • 5-Year yields are now at 16 year highs, having traded to 4.80%
    • The 10-Year too is now at 16 year highs today, trading to 4.86% after briefly seeing yields above 5.00% for the first time since 2007
image-20231023142225-1
Source: Bloomberg
 
  • In the swap market, while the chance of another hike is slim, so are the chances of a rate cut happening anytime soon – in turn lifting rates there too
  • The notable selling on the long end of the yield curve is due to a confluence of factors investors could no longer ignore:
    • Government deficits showing no signs of improving – generating a flood of new Treasury supply hitting the market (and with more to come in the years ahead)

      • While this is nothing new, the Fitch downgrade in August, in conjunction with government shutdown threats every few months, makes it top of mind for investors
    • The largest buyers of that supply stepping back: the Fed through quantitative tightening operations and foreigners no longer seeking out returns abroad (mainly Japan)
    • And, perhaps most importantly, the market coming around to the idea that the Fed’s “higher for longer” message is real
  • It wasn’t for a lack of trying on the Fed’s part, they have been using the phrase “higher for longer” for well over a year now. But not until a resilient US economy humbled recession forecasters (myself included), did long term yields trade on it
  • Powell, likely frustrated that it took so long, is welcoming the bear steepening of the curve. It’s been a major factor in tightening financial conditions lately and could help those on the committee feel more comfortable holding rates steady vs. hiking further
    • Several Fed Presidents and Governors reiterated that point this week:

      • Waller: “I believe we can hold the policy rate steady and let the economy evolve in the desired manner”
      • Williams: “My current assessment is that we are at, or near, the peak level of the target range for the federal funds rate”
      • Barkin: “We are walking a fine line – if we under correct, inflation re-emerges. If we overcorrect, we do unnecessary damage to the economy…we have time to see if we have done enough”
      • Harker: “I believe that we are at the point where we can hold rates where they are”
    • That growing sentiment from the Fed is, in part, the reason frontend rates like the 2-Year has been trading flat to sideway despite whats been happening on the long end
image-20231023142457-2
Source: Bloomberg
“The best cure for high prices, is high prices” – might just work with interest rates too
  • Not only are nominal bond yields getting attention, but for the first time since 2010, the bond market is offering higher relative returns for investors than their equity counterparts
  • A company’s earnings yield – the yield you would receive if a company paid all its profits as dividends – is often used by assets managers to compare the relative returns equities offer compared to prevailing interest rates (like the 10Y Treasury or AAA rated corporate bonds)
  • Textbooks suggest that investors in equities should demand an extra risk premium of several percentage points above risk-free rates in their earnings yield to compensate them for the higher risk of owning stocks over bonds 
    • And for the vast majority of the past 20 years – that has held true
    • Except for a few brief periods of time, including today, where that dynamic flipped the other way
    • In each of those periods, when bonds offered investors higher returns with less risk than equities, funds flowed in that direction and in the months that followed – bond yields retraced lower on the back of this uptick in demand
image-20231023142639-3
Source: Bloomberg
So, what does this mean?
  • It could mean that rates are overvalued, trading near a top at current levels, or it could mean nothing – like in the 1990s when this spread was in the bond market’s favor for much of the decade
  • But for what it’s worth – there is little in front of us today to suggest rates like the 10-Year Treasury won’t at least try to break through the psychological 5.00% level (again) before being truly tested
    • Especially with the November 17th government shutdown deadline quickly approaching and yet another credit rating downgrade a likely consequence
  • Further out though, the ebbing of inflation + the attractive nature of risk-free 5.00% yields may keep a lid on rates moving materially higher from here

 

For now, the hedging playbook remains:

  • Lock in lower interest rates with 1–2-year swaps, 3–5-year downside protected swaps, or long cap strategies
  • The goal being: Hedge the near-term risk the Fed does hike again (something that isn’t fully priced in), capture interest rate savings that the market is offering, but keep a conservative maturity date to leave the door open to restructure or revisit your interest rate strategy sooner rather than later
 
 
Related tags: Interest Rates

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