Investor appetite for bonds has been on the rise in recent times, driven by market expectations of more rate cuts by the Federal Reserve. This sentiment has been fueled by data indicating cooling inflation and a softer U.S. job market. The Fed’s recent indication of a potential rate cut in September has further bolstered this trend, with some market participants even speculating on the possibility of a larger 50-basis point cut next month. However, it is important to note that this shift in market sentiment may be based on limited evidence, as the rise in the unemployment rate is primarily driven by a growing workforce rather than falling employment.
Despite the current market narrative, it is essential to exercise caution when considering long-term bonds, especially following the significant drop in yields over the past month. In this environment, short-term paper, including credit, may offer a more attractive option as it can provide similar income to long-term bonds with less sensitivity to interest rate fluctuations. The recent decline in short-term yields supports this view, and there is a possibility that long-term yields may see an upward trend in the future.
Looking ahead, we anticipate that long-term yields will eventually rise as investors demand more term premium to compensate for the risks associated with owning long-term bonds. While the return of term premium may take time, we maintain a tactically neutral stance on long-term Treasuries due to the volatility in yields driven by shifting policy expectations. Despite concerns over higher rate cut expectations and economic growth, the labor market remains resilient, with job gains continuing and employment on the rise.
There are several catalysts that could potentially drive the return of term premium, although the timing of these events remains uncertain. Factors such as the U.S. election shifting focus to the fiscal outlook and the Federal Reserve’s balance sheet adjustments could play a significant role in boosting term premium. Additionally, the Bank of Japan’s policy shift towards managing inflation risks could impact global bond yields and investor preferences for local bonds over foreign bonds.
In conclusion, while the start of rate cuts may signal a shift in monetary policy, it is important to remain cautious and avoid overreacting to volatile market data. Income generation through short-term bonds and credit may be a more prudent strategy in the current environment. Additionally, maintaining an overweight position in Japanese stocks could prove beneficial, especially given the potential impact of the BOJ’s policy adjustments on global term premium.