Source: AFP.
US Treasury (UST) yields have been pressured upwards in the past week on firm US economic data releases and some progress from the debt ceiling debate. In addition, several Federal Reserve (Fed) officials dialled up the hawkish rhetoric although Fed Chair Powell last Friday sounded a more neutral tone, saying it remains unclear if interest rates will need be raised further, reiterating future rate hike decisions will be data dependant. That has altered the outlook for the futures market; with investors reducing expectations of Fed rate cuts in 2H23 while increasing the chance of a June rate hike.
Source: AFP.
While the market grapples with pricing the appropriate policy rate trajectory, UST yields are swinging around correspondingly. Near term, we see yields biased towards the upside based on firm economic data and a potential resolution to the debt ceiling. So far, there is not enough conclusive evidence of substantial economic weakness in the US while investors remain concerned that inflation will stay sticky. Hence, the probabilities around different peak levels for the fed fund rate are still a moving target.
Our base case is for a pause at the Fed’s Jun meeting, but the prospect of a hike in the months ahead remains a tail risk. Recall that central banks from Malaysia and Australia surprised by raising benchmark rates in May, citing inflationary pressure after pausing since Nov 22 and Apr 23, respectively.
The tail risk of a further Fed rate hike is keeping the US yield curve inverted (2Y UST yielding more than 10Y UST). Normalisation will only take place when the economy softens. With the current tight US labour market, our base case is for rate cuts to happen in 1Q24. A rate cut will pave the way for the yield curve to drift lower, and eventually steepen the UST curve.
Source: Bank of Singapore, Bloomberg.
Currently, short duration strategies offer generous yields, but we think extending into longer duration should not be overlooked. The goal is to accumulate duration at reasonable yield levels to prepare for an eventual pivot by the Fed towards rate cuts. History from the previous five hiking cycles dating back to 1994 shows that longer dated US Investment Grade (IG) and UST bonds (10Y+) consistently outperformed front end (1-5Y) and intermediate (5-10Y) maturities at the conclusion of rate hiking cycles, over 3, 6 and 12 months after the last rate hike.
Therefore, we recommend extending into longer duration to lock in higher yields as we approach the end of the Fed hiking cycle.
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