Investors skeptical about a “soft landing” for the U.S. economy think now is a good time to consider buying long Treasury bonds.
That’s because the economy looks to be revving back up, 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 already has 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 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 hike rates to mitigate inflation risks “posed by growth or labor-market data that remains too strong.”
That has investors focused on inflation data due Thursday and on Friday’s jobs report for August for hints as to if 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 key 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. Bond prices move in the opposite direction of yields.
The 10-year Treasury rate eased back to 4.2% on Monday, while the 30-year Treasury rate BX:TMUBMUSD30Y was at 4.28%, according to FactSet. But higher long-term rates in 2023 already have pushed up borrowing costs across parts of the economy, including recently by nudging the average 30-year fixed mortgage rate to 7.23%, the highest since 2001.
Despite recent pressure on rates, 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 global financial crisis.
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.”