Investors who are skeptical about a “soft landing” for the U.S. economy think now is a good time to consider buying long Treasury bonds, particularly after a wave of volatility in August pushed yields higher.
Yields rose in August as economic growth looked to be revving back up in recent data with the Federal Reserve Bank of Atlanta estimating a 5.9% gross domestic product growth rate in the third quarter, even though the Federal Reserve has already jacked up interest rates to their highest level in 22 years.
“A soft landing isn’t a destination. It’s a transition point,” said John Madziyire, senior portfolio manager and head of U.S. Treasuries and TIPS at Vanguard Fixed Income Group. “Right now, you can see the market is pricing in a soft landing, with growth holding up. That’s a perfect scenario for the Fed.”
But Madziyire also worries that the labor market remains too strong and that economic growth must slow to get the Fed closer to its 2% annual inflation target. “We are not going to stay in a soft landing,” he said. “At some point something has to give.”
Labor, growth in focus
That something could be the Fed getting even more aggressive with its inflation fight or economic data finally starting to cool, given the lagging effects of rate hikes.
Fed Chairman Jerome Powell, in his Jackson Hole, Wyo., speech on Friday, talked of both possibilities, including the scenario that getting to the Fed’s inflation target “is expected to require a period of below-trend economic growth as well as some softening in labor-market conditions.”
Mizuho Securities’ U.S. economists, in a Monday note, said Powell’s speech emphasized that the Fed could also raise interest rates again to mitigate inflation risks “posed by growth or labor-market data that remains too strong.”
As a result investors are focused on the July personal consumption expenditure index inflation data due Thursday and on Friday’s U.S. Labor Department jobs report for August for hints as to whether the Fed will opt to hike or hold rates steady in a 5.25% to 5.5% range in September.
Higher borrowing rates can threaten growth at companies, a driver for equity prices. On the flip side, higher bond yields serve as income for investors.
A rough August
A volatile August sent the 10-year Treasury yield BX:TMUBMUSD10Y above 4.3% to its highest since 2007 and evaporated yearly returns in the Treasury market, after Fitch Ratings cut its AAA ratings for the U.S. to AA+, the Treasury Department released a big $1 trillion borrowing need for the third quarter and other factors contributed to a selloff.
However, the 10-year Treasury yield eased back to 4.14% on Tuesday, while the 30-year Treasury yield BX:TMUBMUSD30Y was at 4.24%, according to FactSet. Higher long-term yields in 2023 already have pushed up borrowing costs across parts of the U.S. economy, including recently by nudging the average 30-year fixed mortgage rate to 7.23%, the highest since 2001.
For August, the benchmark 10-year Treasury yield was on pace for its largest 1-month yield rise since February, while climbing about 71 basis points in the past four months, according to Dow Jones Market Data.
Despite recent upward pressure on yields, an LPL Research team said Monday they are recommending a modest overweight to fixed income funded from cash, with the expectation that the 10-year Treasury yield averages around 4% for the next decade, or roughly the average in the decade before the 2008 global financial crisis.
Related: Investors parked heavy in cash may be making a ‘mistake’, Nuveen says
The LPL team also noted that the early 2000s saw the Bloomberg Aggregate Bond Index AGG roughly produce an average 6% annual return. However, higher starting Treasury yields would translate to high fixed-income returns, wrote LPL’s Lawrence Gillum, chief fixed-income strategist, and Jeffrey Roach, chief economist.
With a backdrop of higher yields, Vanguard’s Madziyire said pension funds and other institutional investors sidelined by recent ructions in the Treasury market likely will be returning as buyers.
“What we did see was a dearth of demand, with the bond vigilantes driving the markets higher in terms of yield,” he said. “Slowly, as volatility comes down, you’d expect long-term investors to come in and buy at attractive yield levels.”
U.S. stocks were higher Tuesday, with the S&P 500 SPX, Dow Jones Industrial Average DJIA and Nasdaq Composite COMP looking to advance for a third straight session.
Read: Pimco emerges as a buyer in Treasury market selloff, says Bond Vigilante theme ‘a bit extreme’
