Investor appetite for bonds has grown. That comes as markets have priced in more Fed rate cuts on data showing cooling inflation and a softer U.S. jobs market. The Fed opened the door to a September cut last week, as we expected. Then the payrolls data stoked recession fears and market hopes for a large 50-basis point cut next month. We see this as another flip-flop in the market narrative with little evidence backing it: Unlike in recessions, a growing workforce is driving the rise in the higher unemployment rate, not falling employment. We stay cautious on long-term bonds, especially after the sharp yield drop over the past month. We still favor short-term paper including credit: It can offer similar income to long-term bonds with less sensitivity to interest rate swings. See the chart. That view has played out as short-term yields have dropped – and we think long-term yields can climb anew.
We think long-term yields will eventually climb in the long term as investors demand more term premium, or compensation for the risk of owning long-term bonds. The return of term premium will take time, so we stay tactically neutral long-term Treasuries as yields swing sharply on shifting policy expectations. We believe last week’s yield drop on higher rate cut hopes and growth fears are overblown. The labor market remains resilient: jobs gains are slowing but strong, employment is still rising and layoffs are not increasing. And even if near-term U.S. inflation is proving volatile, ongoing pay pressures and a shrinking workforce support services inflation longer term. That, and large U.S. fiscal deficits in the future, could keep the neutral interest rate – one that neither stokes nor restricts growth – higher than pre-pandemic.
Catalysts ahead
We see catalysts for term premium’s return, but timing is uncertain. One catalyst: the U.S. election likely shifting focus to the fiscal outlook. The Treasury’s bond issuance calendar suggests it doesn’t need to make major changes for now. We think net issuance will eventually need to climb to match the pace of government spending. Markets struggling to absorb this supply could boost term premium. The Fed altering the size of its balance sheet or the maturity of its bond holdings is another catalyst. It’s still a big buyer, purchasing 10% of 10-year and 30-year bonds in 2023 and holding about 30% of bonds with maturities longer than 10 years in circulation, based on analysis of New York Fed data by our portfolio managers. The mix of buyers also matters: While foreign buyers have retreated, U.S. households are increasingly stepping in to buy.
The BOJ policy shift also matters for global term premium. Its move to more actively manage inflation risks could boost bond yields and prompt domestic investors to favor local bonds over foreign bonds, especially in the U.S. and euro area. We see a greater risk of a BOJ policy misstep and are reviewing our overweight to Japanese stocks. A stronger yen had limited the return hit to our currency unhedged preference, with the MSCI Japan down 4% from its recent peak as of Friday. But we have lower conviction given the policy uncertainty.
Bottom line
The start of rate cuts doesn’t mean this will be the typical easing cycle, and markets can overreact to volatile data given lighter trading activity. We prefer income in short-term bonds and credit, and trim our overweight to Japanese stocks.
