Tuesday, May 23, 2023
- U.S. Treasury yields are generally higher over the past week with the two-year trading around 4.4%. The 0.50% increase in the two-year yield since last Monday is largely due to markets pricing out rate cuts later this year. Our view was that the market was too optimistic for the amount of rate cuts being priced in. Markets now expect one cut this year, which may still be too optimistic, unless financial conditions deteriorate. That said, we think we’re close to the end of the recent rise in Treasury yields.
- News reports suggested there was “optimism” surrounding the debt ceiling negotiations but still no deal. Treasury market pricing suggests the greatest risk of delayed payment will occur for those securities that mature on or after June 6. Currently, the Treasury Department has around $60 billion in its operating cash account. For context, the Treasury’s cash balance got to around $11 billion in 2011. Our base case remains a deal gets done in time, but the clock is ticking.
- Moreover, the Treasury Bill (T-bill) market is fairly disjointed currently with T-bills that mature on May 30 yielding 2.89% (the fed funds rate is 5.25%) and those that mature in June 8 yielding 5.81%. The difference in yields between the two securities is at extreme levels as more market participants are avoiding those securities that could be negatively impacted by a delay payment from the Treasury. The longer the negotiations drag out, the more it is likely we’ll continue to see higher yields for the securities maturing in June.
- Interest rate volatility (as per the MOVE index) remains elevated relative to the last decade but in line with the periods before central banks’ quantitative easing. We think interest rate volatility will remain elevated as long as the Federal Reserve (Fed) remains committed to reducing the size of its balance sheet. The most interest rate sensitive fixed income assets are likely at higher risk of volatility. But buy and hold investors should remember that bonds pay back principal at par regardless of intra-period volatility.
- After the recent back-up in yields, core fixed income sectors are trading close to levels last seen in early March and above longer-term averages. We think the risk/reward is more favorable for core bond sectors over plus sectors with the exception of the preferred securities market. As such, we think the recent move higher in yields is an attractive opportunity for investors to add to high quality fixed income.
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