The yields on 10-year U.S. Treasurys could rise to between 3.5% and 4%, according to asset managers, on the expectation of rising interest rates. But that sort of spike in yields could see capital flow straight back into U.S. government debt.
A combination of strong economic data and a hawkish tone from the Federal Reserve Chairman Jerome Powell facilitated a sell-off of 10-year U.S. Treasurys that took yields to a seven-year high of 3.23% at the close of trading Oct. 5, an increase of 18 basis points in the week.
"A yield of 4% at some point in the next few months would not surprise me. Ultimately they may rise even more than that," wrote Chris Iggo, fixed-income chief investment officer at Axa Investment Managers.
The trigger for the sell-off was surprisingly strong U.S. jobs data, as the unemployment rate fell to 3.7% from 3.9%. This is the lowest rate since 1969 when then-U.S. President Lyndon B. Johnson was simultaneously spending heavily on his Great Society program and funding the Vietnam War. This was the so-called guns-and-butter fiscal policy.
Current President Donald Trump has also boosted employment, by turning on the fiscal taps. The strength of the jobs data appears to have convinced the market that interest rates will continue to rise as Powell has long indicated.
"The latest data solidifies the prospect of a December rate increase," wrote Bob Schwartz, senior economist at Oxford Economics. He said the spike in yields could be a signal that the central bank should hike more quickly, "lest the Fed falls behind the inflation curve and is forced to take harsher growth-stifling measures next year to counteract inflationary pressures."
The rise in yield in longer-dated debt has quietened talk about the flattening curve on the spread between 10-year and two-year Treasurys. Yet while the premium for holding longer-dated debt began the week of Oct. 8 at its highest level since June 26, it remains at just 35 basis points. Pimco is among the asset management companies recommending holding shorter-dated debt, pointing to the lack of reward for holding longer-term bonds for the extra risk.
More debt, more yield?
The increasing borrowing requirement of the Treasury to fund its budget deficit and the cost of hedging U.S. bonds for foreign investors could see yields rise further. "Demand for longer-dated fixed income was supported in the third quarter by flows from U.S. corporate pension funds ahead of tax changes, but these flows may abate in the fourth quarter, just as Treasury supply picks up," said Mark Dowding, co-head of developed markets at Bluebay Asset Management. Bluebay is "slightly short U.S. rates in the second half of September" as a result.
Hedging costs are a significant burden for European investors. Gary Kirk, a partner and portfolio manager at TwentyFour, drew the comparison between U.S. Treasury yields and Italian government securities, known as BTPs. "The differential in the underlying interest rates has driven the cost of hedging to extreme levels, with the current cost of converting a dollar yield to a euro yield around 290 basis points for a one-month term," he said. On a yield of 323 basis points, after hedging, the euro yield would be just 0.33%, whereas BTPs were far more attractive, trading at 3.56% as of 11:59 a.m ET on Oct. 8.
The possibility of a further Fed hike in December, followed by another three in 2019, would result in the top of the Fed Funds range being at 3.25%, whereas euro refinancing rates are expected to still be negative. "So this foreign-exchange hedging cost basis is only going higher in the short to medium term. It is therefore critical to consider all assets on a currency-adjusted playing field, and remember that the foreign-exchange hedge can be a benefit as well as a cost," Kirk said.
However, if yields continue to rise sharply, this could lead to a risk reversal and a flight back to quality, according to Dowding. "In this context, 10-year U.S. yields above 3.3% may not be a problem, but a near-term test of 3.5% could be more worrying and wage and inflation data could provide a catalyst," he wrote.
There remains a strong demand for the long end of the U.S. market from domestic pension funds, according to AXA's Iggo. "At some point, when the risk cycle turns, investors will be glad of the fact that they own fixed income. Especially in U.S. dollar-denominated portfolios," he wrote.
It is also possible that the market has undertaken its major readjustment in factoring in more rate rises. "We think this was more or less a one-off adjustment. Yields may obviously rise a little further, but we think the rise will be modest," wrote Han de Jong, chief economist at ABN AMRO.