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Why the bond market sell-off is almost over

FED RATE
John Zich | Bloomberg | Getty Images

Since the U.S. elections in November, 10-year Treasury yields have risen markedly, as, of course, has the S&P 500. The current steepness of the yield curve – in other words, the difference in yield between bonds with shorter and longer maturities – is creating an opportunity in the Treasury market. On a six-month view, we believe that 10-year Treasurys – which yield more than their shorter-dated equivalents – now look like an attractive home for money relative to cash.

The continued improvement in the U.S. economic situation has been reflected in the Federal Reserve's bias towards tightening monetary policy, along with market expectations of fiscal stimulus under President Donald Trump. This improvement led to a substantial sell-off in government bond markets after the U.S. election in November. After rising roughly 0.6 percentage points, the 10-year Treasury yield has since traded in a narrow range around 2.5 percent.

Following this move, we believe that the sell-off has largely run its course. Historically, 10-year Treasury yields have tended to peak relatively early in the Fed rate tightening cycle, as markets typically move swiftly to price in a full series of rate hikes.

In addition, a continuation of stimulative monetary policy in much of the rest of the world should dampen further increases in U.S. 10-year rates, as global investors hunt for yield. As a result, over a medium-term investment horizon, we think the 2.5 percentage point difference between the yields on 10-year Treasurys and cash is high enough to compensate for 10-year Treasurys' investment risks.

Recent statements by Federal Open Markets Committee members have led us to anticipate two or three 0.25 percentage point rate hikes this year. We have revised up our forecasts for Treasury yields with a tenor of up to five years.

"On a six-month view, we believe that 10-year Treasuries – which yield more than their shorter-dated equivalents – now look like an attractive home for money relative to cash."

However, we agree with Chair Janet Yellen's statement on March 3 that the Fed has not fallen behind the curve and that the pace of monetary tightening will remain gradual. We expect the yield curve to flatten, with shorter-dated yields moving higher while longer-dated yields remain contained. Our forecasts for 10- and 30-year Treasury yields are unchanged.

Combining the 2.5 percentage point yield difference with roll-down effects, the position should be profitable even if yields rise to 2.8 percent in one year's time. Such a rise would need to see a substantial increase in the expectations for monetary tightening, or a sharp rise in the "term premium." (The "term premium" is the excess return investors usually expect to compensate for the uncertainty related to holding bonds with more distant maturities, rather than holding and rolling over shorter-duration securities.)

We believe neither of these risks is likely to materialize. An accelerated pace of Fed rate hikes is not our base case given that the rate of wage growth has been relatively subdued. The recent strength of the U.S. dollar should also restrain inflation. Nor do we expect a rise in the term premium, which has historically moved lower through the hiking cycle as uncertainty is resolved.

Adopting an overweight position in 10-year Treasurys relative to an underweight in cash also has the benefit of diversifying investors' tactical asset allocation if they hold overweight positions in global equities or U.S. stocks versus government bonds. Ten-year Treasurys tend to perform well when such risk assets come under pressure.

Nevertheless, despite this opportunity in Treasurys specifically, we believe that encouraging market momentum and low volatility continue to justify a moderately risk-on stance. We remain overweight U.S. equities, global equities, and U.S. high yield credit relative to government bonds.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow him on Twitter @UBS_CIO and on LinkedIn at www.linkedin.com/in/markhaefele.

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