By Ashok Bhatia, Neuberger Berman Fixed Income Co-Chief Investment Officer
Government bonds were sold rapidly. Here’s why now is not the time to buy back.
Over the past six weeks, global government bonds have been selling off rapidly.
The yield on two-year U.S. Treasuries has risen nearly 50 basis points since hitting a low in mid-September. The five-year and 10-year yields both rose about 60 basis points to 4.0% and 4.2%, respectively.
Is it time to buy again?
Apparently not. In fact, this could be just the beginning of a surprisingly sustained rise in yields.
Fed may pause
Earlier this year, there was discussion that bond market pricing is all about the destination of policy interest rates, not their journey. The important thing is that there will be a rate cut eventually, and it was too early to think about how quickly it would happen and how quickly it would happen once it started.
In August, as the Federal Reserve approached its first interest rate cut, we told investors to be on the lookout for changes. Had travel direction been incorporated, interest rate and bond market pricing could have been more sensitive to travel details, such as the estimated size, frequency, and regularity of reductions.
Recent developments suggest that the market’s pricing for the final federal funds rate is approximately 3.5%. However, the futures curve suggests a near-straight line reaching 3.5%.
By contrast, the Fed is likely to cut rates by 0.25% next week and in December, and possibly by 100 basis points and pause as early as the first quarter.
Growth and inflation exceed expectations
Bond yields rose after a weak August, with a series of positive U.S. announcement surprises in September, including a blockbuster jobs report and better-than-expected retail sales and inflation.
Last week’s release of the U.S. Purchasing Managers Index, new home sales and unemployment claims added to this trend. According to the Atlanta Fed’s GDPNow model, the U.S. grew at 3.4% in the third quarter, and the U.S. was one of the few countries last week to have its 2025 growth forecast revised upward to 2.2% by the International Monetary Fund.
Meanwhile, rising Middle East risks and uncertainty about the US election have heightened concerns about inflation and fiscal sustainability. Neither US presidential candidate intends to tackle the US budget deficit, and Donald Trump’s recent rise in the polls makes particularly inflationary tariff policies more likely. These risks are priced into market inflation expectations and gold, for example.
Faced with 2.5% GDP growth and increasingly stubborn inflation, it’s hard to imagine the Fed will mechanically cut rate after rate cut next year.
Prepare for volatility
This can have a significant impact on the yield curve for two reasons.
First, if the Fed pauses, the possibility of a return to rate hikes may be on investors’ minds. As “The Destination, Not the Journey” suggested, one of the main factors supporting bonds over the past 12-18 months was the inevitability of an eventual rate cut.
Second, the recent sell-off has only brought yields back to the levels they were in late July, just before very weak US jobs data and the unwinding of the yen carry trade led to big buying in bonds. It would not be surprising to see US five-year bond yields rise another 50 basis points from here, returning to mid-2024 highs.
With this scenario in mind, our clients’ portfolios with the most freedom to adjust duration are currently at the lower end of our range at approximately 3.5 years, which is just over half the duration of the major investment grade benchmarks. That’s about it.
They’re also wary of corporate credit, as spreads on U.S. investment-grade corporate bonds are the narrowest they’ve been in nearly 20 years, and a return to 4.5% on the five-year bond could trigger a disorderly exit. Investors looking for exposure may be better off looking to structured products such as investment-grade collateralized debt obligations (CLOs) and mortgage-backed securities (MBS), which still have higher spreads.
The mood will change in September, with bond investors needing to brace for further downside volatility.
