Bond math is more than yield

This may have been one of the most important and significant weeks for global fixed income markets, and perhaps markets generally, in recent months … even though not much actually happened.

Of course, things did happen, but really only on the fringes. Yet it was enough to seemingly change the entire narrative that has prevailed over markets since central banks began their respective aggressive rate hike campaigns.

A tantalizing trifecta

There were three key events this week: the Bank of Japan’s (BoJ) meeting; the U.S. Treasury Department’s Quarterly Refunding Announcement; and the Federal Reserve’s Nov. 1 meeting.

Markets feared the BoJ was on the cusp of abandoning its yield curve control program, which has capped the level at which policymakers would allow the 10-year Japanese government bond yield to rise before intervening at one percent. That cap was removed, but only softly so. It is now simply a reference level around which the central bank will operate with “flexibility.” But with BoJ Governor Kazuo Ueda stating explicitly that he didn’t expect yields to rise much further than one percent, it remains at least a soft cap. And that mattered for the second event. Rising domestic yields in Japan could cause domestic investors there to repatriate cash—largely held in U.S. Treasuries, and a key source of foreign demand—to the Japanese market.

And that fading demand for U.S. Treasuries sets the stage for the Treasury Department’s funding needs over the next three months, in our view. It was back in early August when the Treasury Department announced greater financing needs on the back of rising deficits, largely due to lower-than-expected tax receipts and falling remittances from the Fed as it marched forth with quantitative tightening. The result was bigger increases to longer-dated Treasury auctions, particularly for the 10-year note and 30-year bond.

That surprise has largely contributed to the ongoing rise in Treasury yields, with the yield on the benchmark 10-year note briefly exceeding five percent in October, having traded below four percent just prior to the Treasury Department’s announcement. The chart below shows a model of the 10-year Treasury yield broken down into two simple components: the market’s expectations for the path of the fed funds rate, and the embedded term premium—or the yield demanded by investors for the various perceived risks of holding longer-dated bonds, including more supply and less demand. The roughly 100 basis point rise in the 10-year Treasury yield since July 31 has been entirely explained by the term premium; the expected path of the Fed’s policy rate has actually declined slightly.

Deconstructing the 10-year Treasury yield: Drivers of higher yields matter to the Fed

Line chart showing a simple model of two key drivers of the 10-year Treasury yield since July 31, 2023: the term premium for holding longer-dated bonds, and the implied future path of the Fed Funds short-term rate. Since July, all of the rise in the 10-year yield can be attributed to higher term premiums demanded by investors, as the expected path of short-term rates has actually declined.

• U.S. 10-year yield
• Term premium
• Expected fed funds rate

Source – RBC Wealth Management, Bloomberg; term premium and expected fed funds rate based on Adrian, Crump & Moench model, data through 10/31/23

And that rise in yields driven by term premiums set the stage for the Fed. Higher yields, falling stock prices, and dollar strength since August have fueled starkly tighter financial conditions, to some of the tightest levels of the past year, even though the Fed has only raised rates once in the past six months. Policymakers highlighted tightening financial conditions in their policy statement. This comes at a time when Fed officials largely believe that rate hikes to this point are only just beginning to bite on economic activity. Tightening financial conditions also act with a lag on the economy, with those two factors potentially acting as a double headwind. Fed Chair Jerome Powell struck a more cautious tone than he has in some time, likely as a result. We maintain our view that the Fed is done with rate hikes, but now with only greater conviction.

Given swelling optimism, the S&P 500 has gained 4.7 percent since Oct. 27, while the 10-year Treasury note yield has now fallen around 32 basis points from the October high to 4.67 percent.

Off the short end

With even greater confidence that the Fed has indeed delivered the final rate hike of this cycle back in July, we believe it’s time to take portfolio positioning more seriously as markets turn their focus to the next phase of the cycle.

Since the Fed began raising rates in March 2022, being in cash, money market funds, or short-dated Treasury bills has clearly been the optimal strategy. Over that stretch, the Bloomberg U.S. Treasury Bellwethers 3 Month Total Return Index has gained 5.8 percent, whereas the Bloomberg U.S. Long Gov/Credit Index has dropped a significant 24.1 percent.

The chart below may look convoluted, but it tells a simple and perhaps unsurprising story: when the Fed is done raising rates, bonds start to perform. And often handsomely so. But, in our view, it also shows that it could mark the point at which investors should start exiting bond positions in short-dated securities in favour of intermediate and longer-dated bonds. In all previous cycles, the last Fed rate hike has marked the point at which bonds with more duration—or interest rate risk—outperform cash and cash equivalents.

Fixed income duration strategy after the last Fed rate hike

Line chart showing how various bond maturities have performed following the end of previous rate hike cycles. In most cases, and at most points in time, longer-dated bonds have outperformed short-dated bonds. Additionally, cumulative bond performance had never been negative after the last Federal Reserve rate hike of a cycle until this one. Following the last Fed rate hike in July, 5-to-10-year bonds are down 3.5%, while 10Y+ bonds are down 11%.

• Last rate hike of cycle
• Long Gov/Credit Index
• 3-month Treasury Index
• Fed funds rate
• 5–10Y Gov/Credit Index

Source – RBC Wealth Management, Bloomberg U.S. Gov/Credit Bond indexes; data through 11/1/23

The bond math is simple: the average yield on the Bloomberg 5–10Y Gov/Credit Index is currently 5.4 percent, with an average dollar price far below par at just $87. When markets fully price not just the end of rate hikes, but the timing of the first rate cut, yields would likely fall, and bond prices—which move inversely to yields—would rise. That price appreciation on top of coupons earned would only amplify total returns. On the flip side, we think reinvestment risk exists from staying too short and rolling over short-dated bonds into an ever-lower yield environment. It’s still early days, but if the Fed’s July rate hike does prove to be the last, then recent market action has been at odds with history. Recent negative bond performance presents appealing entry points, and we think the intermediate 3- to 10-year part of the yield curve offers the most attractive risk/reward tradeoff at the moment.