June 19, 2024


The author is global head of fixed income research at HSBC, based in Hong Kong

There are three supporting arguments for the battered US Treasury bond market: fading momentum, restoration of value, and opportunity cost. These hold regardless of your long-term fundamental view on interest rates and yields.

First, the momentum behind the bond bear market is gradually subsiding. We can see this from the change in the trajectory of the monetary policy-sensitive three-month US Treasury bill. Starting in January 2022 with yields near zero, it rose at a pace not seen in four decades after the US Federal Reserve’s drastic turn. After reaching 1.67 percent in the first six months of 2022, it rose to 4.50 percent by the end of the year.

In 2023, a dramatic recession has occurred. An additional 1 percentage point, reaching 5.50 percent in the first week of September, compared to an increase of 4.50 percentage points last year. In monetary policy terms, the extreme tightening was seen more than a year ago. The overwhelming consensus among forecasters is that there will be no hikes at the September 20 meeting, and based on the futures market, many think the Fed will not make any further hikes this cycle.

Now the challenge for policy makers is to stop the market from getting ahead of itself and create conditions for a rate cut. At least for now, the Fed is well served by the “higher for longer” mantra, as it is still waiting for the delayed impact of the hikes to kick in. Policy makers call this forward guidance. The market knows that events or data will drive decisions.

Second, attractive valuations are enough to attract bond investors. For the 10-year Treasury, the absolute value is shown by the real rate, after taking inflation into account, which sits on top of the trend for real GDP near 2.0 percent, which the Fed has projected at 1.85 percent. This is not only unusual, but it means investors can diversify away from the stock market, and do so with bonds that traditionally have less risk.

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Of course, this is unless the economic growth trend is revised higher, justifying further increases in the real rate. We doubt this. Fiscal largesse has largely driven recent growth, and the rising debt stock will weigh on future growth through its cost of servicing.

The relative valuation of Treasuries compared to other G7 government bonds also looks attractive, a measure of how far Fed policy has moved into hawkish territory compared to other central banks. And it is the riskier corners of fixed income, debt and emerging market local rates that are performing well this year. If holding them is based on the last turn in the US rate cycle, it is certainly better to hold the bonds that will yield the most gains, i.e. US Treasuries.

Third, there is an opportunity cost for investors who are being inactive from this bear market, who are currently stuck with a pile of Treasury bills – short-term government debt that pays interest at maturity. Investors may ask why take the risk of owning a 10-year security, which is currently priced at about 1 percent less than a Treasury bill? The intuitive approach based on yield differences misses the opportunity cost – the potential gain from not choosing other options.

Bonds offer the same fixed coupon throughout their lifetime, so they have so-called higher duration – their price is more sensitive to future interest rate decisions. The duration of the bills is minimum but the reinvestment risk is high, as today we do not know what the yield on offer will be when it matures.

An example is comparing a 10-year bond yielding 4.25 percent with a bill yielding 5.25 percent. If the yield on the bond fell only 0.125 percentage points, the price gain – when combined with the coupon – would mean that the return would be equal to the higher yield on the bill.

Granted, bond prices can rise and fall, so holding bonds carries more risk for an investor than holding bills. But for context, since the beginning of 2022 – when the Fed tightened – the yield on 10-year Treasuries has increased 2.66 percentage points. This represents a price drop equivalent to 21 percent! Turning this move on its head, with bond yields falling back to levels last seen in 2007, if the move reverses from 2022 onwards, the opportunity cost of not switching from bills to bonds could be significantly higher .

In short, momentum and value are more favorable bonds today than they were a year ago, providing some solace for investors considering the opportunity cost of switching from the security of bills. You don’t need to be a Perma bull to buy bonds.

Source: www.ft.com

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