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BlackRock Commentary: U.S. yields: two-way volatility ahead

Jean Bovin – Head of BlackRock Investment Institute together with Wei Li – Global Chief Investment Strategist, Alex Brazier – Deputy Head, and Michel Dilmanian – Investment Strategist all forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.

Key Points

U.S. Treasury view: We turn tactically neutral long-term Treasuries as markets price high-for-longer policy rates but stay underweight strategically. We cut high quality credit again.

Market backdrop: U.S. stocks steadied last week as Q3 earnings season started. Ten-year Treasury yields dipped. U.S. core CPI reinforced why we see the Fed holding policy tight.

Week ahead: China GDP and Japan inflation are in focus this week. We see China on a lower growth path and higher inflation in Japan paving the way for a policy change.

We have been underweight long-term U.S. Treasuries since late 2020 as we saw the new macro regime heralding higher rates. U.S. 10-year yields at 16-year highs show they have adjusted a lot – but we don’t think the process is over. We now turn tactically neutral as policy rates near their peak. The next step is not overweight: we see investors demanding more compensation for bond risk and stay underweight on a long-run, strategic horizon. We downgrade high grade credit further.

We’ve long said higher interest rates are a key part of the new regime. Why? Supply constraints make inflation persistent; bond supply is swelling due to high deficits; and macro and geopolitical volatility abound. That’s why we went underweight long-term Treasuries on a six- to 12-month tactical horizon when yields were below 1%. We expected investors to demand more compensation, or term premium, for the risk of holding bonds. That has started to occur in recent months, but the repricing of Federal Reserve policy rates has been a big part of the yield move (orange area in chart) since the Fed’s first hike in 2022. We see the yield surge driven by expected policy rates nearing a peak. Rising term premium will likely be the next driver of higher yields. We think 10-year yields could reach 5% or higher on a longer-term horizon. Yet the gap between investment grade credit and 10-year bond yields hasn’t widened as we expected, so we further downgrade credit.

We now see about equal odds that Treasury yields swing in either direction. In other words, we see two-way volatility ahead. One reason: The Fed is likely nearing the end of its fastest hiking cycle since the 1980s after raising rates into restrictive territory. We see policymakers shifting to assessing financial conditions. Fed officials said last week that tightening financial conditions due to surging long-term yields are likely doing some of the Fed’s work for it. The U.S. economy has already stagnated for the past 18 months after averaging GDP and gross domestic income – which adds up incomes and profits of households and firms. Further damage from rate hikes will likely become clearer over time. We think these conditions bring us closer to when the “politics of inflation,” or pressure on the Fed to curb inflation, will turn into pressure to stop hurting economic activity with tight monetary policy. We still see the Fed holding policy tight to lean against inflationary pressures.

Yield focus

We think long-term yields have not fully adjusted yet. They will eventually resume their march higher as term premium gradually rises, in our view, to account for greater macro volatility, persistent inflation plus large fiscal deficits and debt issuance. In the near term, inflation is easing as pandemic mismatches unwind from consumers shifting spending back to services from goods. We see inflationary pressures on a rollercoaster ride beyond the near term as an aging population shrinks the workforce, fueling wage and overall inflation. That backdrop begs the question: What will be the neutral policy rate that neither stimulates nor slows activity? Drivers of further yield jumps and tightening financial conditions are up for debate, too. These uncertainties are set to create more volatility in the near term, without yields moving in a clear direction.

We fund our tactical upgrade by further downgrading IG credit tactically after recently going underweight last month. Why cut IG and not the lower quality high yield credit? We have expected U.S. credit spreads to widen due to rate hikes. Yet the IG spread has tightened since the Fed’s first hike, while high yield has widened. We also opt to further downgrade IG rather than high yield to avoid reducing our portfolio risk levels and exposure to risk assets.

Bottom line

We turn tactically neutral long-term Treasuries but stay underweight strategically. Instead of IG credit, we tap into quality in short- and long-term Treasuries and U.S. agency mortgage-backed securities (MBS). Agency MBS carry minimal default risk given the implicit protection offered by the U.S. government.

Market backdrop

U.S. stocks steadied for a second week, while 10-year Treasury yields retreated from 16-year highs hit earlier in the month. We think the volatility in long-term yields is likely to persist, even as central banks have likely reached peak policy rates. Fed comments this week that higher longer-term yields were doing the policy tightening work for them helped confirm this. But a renewed surge in U.S. core services CPI excluding housing reinforced why we think the Fed will hold tight on policy.

Asia is in focus this week: China faces weak consumer and export demand and the economic restart from Covid lockdowns is sputtering. We see the economy resetting lower than the pre-pandemic trend growth rate. Inflation has returned in Japan. We see risks of spillovers to global bond markets as the central bank faces pressure to change its ultra-loose policy.

Week Ahead

Oct. 17: UK unemployment, U.S. retail sales

Oct. 18: UK CPI; China Q3 GDP

Oct. 19: Japan trade data

Oct. 20: Japan CPI


BlackRock’s Key risks & Disclaimers:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of 16th October, 2023 and may change. The information and opinions are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ’forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.


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