State of Flux

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”

-George Soros

The U.S. Treasury market is in an elevated state of flux. The interest rate on 10-year U.S. Treasury note has climbed over 70 basis points (bps) since the start of the year and is in the neighborhood of the cycle high just above 5.0%, which was reached on October 23, 2023. While fixed income investors might be reliving the angst of October, the underlying factors leading to higher Treasury yields appear different this time around.

The 2024 duration selloff has been more orderly evidenced by the fact that implied interest rate volatility has been more contained. The ICE Bank of America Merrill Lynch MOVE Index, which tracks 1-month implied interest rate volatility across the U.S. Treasury curve, is 30% below the October 2023 peak, implying investors are less concerned about large interest rate moves in the near-term.

Year-to-date, the rise in yields has been driven by a rethink of the economic growth and inflation outlook. Stronger than expected economic data pushed the median economist forecast for full-year 2024 real GDP to 2.4%, more than 100 bps higher from the start of the year. Meanwhile, a series of hotter than expected inflation data have sent consensus inflation forecasts for full-year 2024 above 3.0%. Combined, the upgrades to real GDP and inflation, have pushed nominal GDP expectations to 5.5%, which is 160 bps above expectations at the start of the year. This contrasts with 2023 when nominal GDP expectations were largely unchanged over the course of the year. As highlighted in Connecting the Dots last week, this dynamic has caused the market to reprice expectations for the start-date and magnitude of the Federal Reserve’s anticipated interest rate cutting cycle.

One of the main impulses behind the rate rise in October 2023 was the increased concern over the U.S. fiscal trajectory on the back of large-scale deficit spending and the deluge of U.S. Treasury issuance (in Q4 2023 the rolling 6-month issuance reached $1.9 trillion). This caused the market to price in more term premium, the added compensation required to hold longer-dated bonds, into the long end of the yield curve. In 2024, supply concerns have faded, and investors are requiring less premium to hold longer-dated bonds compared to the nadir in October 2023.

The current market setup creates an interesting proposition for U.S. Treasury investors in that should US economic data, particularly the inflation data, soften over the coming quarters we would expect to see a rally in U.S. Treasuries. If inflation were to resume its disinflation trend driven by continued deceleration in shelter price inflation (see Shelter from the Storm ), the market’s narrative could reverse again in the second half of 2024 with possibly lower Treasury yields and more Fed cuts getting priced into the market over the medium term. Maybe it is time to discount the obvious and bet on the unexpected.