The 10-year US treasury yield earlier this quarter broke through the psychologically important 3% threshold – the highest level in four years. Has this created a buying opportunity or is it a falling knife?
Given the recent momentum, investors are justifiably worried about spiralling rates. However, the recent yield rise mostly results from cyclical factors. The structural macro backdrop has not changed much. The long-term case for low yields is intact.
Even cyclically speaking, the support for higher US yields is already weakening. While it is notoriously difficult to call the peak in yields, this suggests to us the bulk of rate move is behind us. At the same time, valuation and return potentials have improved significantly.
Cyclical moves versus structural shifts
Investors often confuse short term cyclical moves with long term structural shifts. For recent yield rises to transform into a lasting upward trend, the drivers need to be structural. More concretely, the nominal growth trend needs to improve. For this to happen, two conditions have to be met – real growth potential has to rise and low inflation needs to belong to the past.
On growth, low productivity and demographics continues to keep a lid on real growth. Fewer new hands available in the labour market and no sign of technological progress transforming into higher productivity is dampening growth potential. The ‘amazonification’ has not made people more productive in aggregate. Hence, stronger growth recently is mostly cyclical of nature – not a structural quantum leap out of the low growth environment. Weakening leading indicators already point towards downside risks to interest rates from here.
What about inflation? An ageing population also keeps wages low via a negative effect on productivity. On top of this, high debt levels and technological progress limit inflation. Hence, the recent rise in inflation is mostly cyclical of nature. Case in point, wages are still lacklustre. In order to see a sustained rise in inflation, wages need to rise.
From a top-down perspective, the upside to yields is therefore limited by fundamentals. From an investor perspective, current yield levels present attractive entry levels.
The increasing appeal of US debt
Rising yields have clearly improved the absolute and relative attractiveness of US bonds. Whether the aim is to maximise real returns, or simply safe haven considerations, is it difficult to ignore US fixed income.
On an absolute return basis, it is clear rising yields equals cheaper valuation and hence higher expected returns. Importantly, real returns have improved as well – despite rising inflation. At the cyclical lows, 2yr US treasuries yielded -2.1 % in real terms. Today, the real yield stands at +0.6%. Long term yields have not risen as much.
Consequently, the nominal yield curve is the flattest since 2007, driven by Fed hikes and short-term issuance by the Treasury. We therefore find the best risk reward in the shorter end of the curve.
The appeal of short-dated debt and MBS
How does the asset class fare in various risk scenarios? First, US core fixed income continues to prove its safe haven appeal and diversification merits. A quick sensitivity analysis helps provide context: 2yr treasury yields, currently at 2.5%, have to climb around 150bps over one year before price declines wipe out coupons. It takes a very hawkish Fed outlook to erase this ‘yield buffer’. Even if the Fed hiked aggressively, riskier assets would also likely suffer.
The case for US core fixed income is not only supported by improved expected returns, especially in the short end of the curve. Its safe haven appeal is very much alive as well. This results in an attractive risk/reward profile in times of rising volatility – even in a rising rate scenario. Importantly, the appeal of US core fixed income is not only about treasuries.
Although often overlooked, agency mortgage-backed securities (MBS) stand out in terms of risk/return. Over the last two decades, the MBS Sharpe ratio is 1.04 – compared to 0.821 for US core fixed income overall. MBS offer a yield pick-up relative to treasuries, with the same credit rating. Relative to investment grade credit, agency MBS have both less credit risk and less duration risk. Amid signs the credit cycle is turning and volatility is past its lows, yield-hungry investors seeking to scale down risks might find agency MBS are a better solution than corporate bonds.
Witold Bahrke, senior macro strategist at Nordea Asset Management