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Fed takes a break
Has the cycle of interest rate hikes in the USA come to an end? This is the subject of intense debate among investors, analysts and economists as we approach the home straight of the 2023 stock market year. To combat high inflation, the US central bank has jacked up its target rate from almost zero in early 2022 to 5.25% to 5.50% now. At the last two meetings in September and the start of November, though, the Open Market Committee stayed its hand. Nevertheless, Fed chairman Jerome Powell does not want to set any end date for the squeeze on monetary policy, let alone talk about rate cuts. Indeed, he continues to direct his focus on forcing inflation down to the stated 2% target. “We are not confident that we have achieved such a stance,” Powell said following the latest decision on interest rates. At the same time, he pointed out that the US economy had an astonishingly strong constitution.
Sharp rise in yields
The markets may be doing at least some of the Fed's work for it. “The financing conditions have tightened considerably over the last few months,” Powell noted. This development had been driven in the main by longer-dated bonds. In fact, there has been a lot of movement at the far end of the yield curve recently, with the yield on the 30-year US Treasury climbing above the 5% mark in mid-October (see graph), a level last seen in the summer of 2007. The interest rate for the long-term bond has risen by around 80 basis points since the end of 2022, while that for the 20-year version has jumped higher still. Pimco does not see the latest movement as having been driven primarily by concerns over inflation or other rate hikes by the Fed. Rather, the fixed-income manager cites the diminishing fears of recession as the central cause.
Fixed-income giant with a clear opinion
“Steepening of the yield curve creates a compelling opportunity for investors in money markets to consider adding longer-duration assets, in our view,” write the Pimco experts in a blog post. At the moment starting yields were high relative both to history and to other asset classes on a risk-adjusted basis. This could create a “yield cushion” amid a still highly uncertain outlook. “In addition, bonds have the potential to earn capital gains and diversify portfolios,” the authors reckon. Pimco otherwise shares the Fed's assessment that the financial conditions have already tightened. This would make new debt more expensive and thereby possibly slow down economic activity, which could in turn lead to a loosening of monetary policy.
A time for silence
We are not quite that far yet. What is certain, though, is that Jerome Powell will soon fall silent. On 2 December the “blackout period” ahead of the Open Market Committee meeting starting ten days later will begin. During this time high-ranking representatives of the US central bank refrain from passing comment on the economy, monetary policy and interest rates. The markets are in any case pretty unanimous that there will be no increases in rates either on 13 December or in the following months. According to the CME FedWatchTool, it is even possible that there will be a first cut in the target rate in June 2024 (see graph). In that regard the tool, which is based on the conditions on the futures markets, chimes with Pimco’s view. Should interest rates actually start trending downwards next year, now may well be the right time to build up a position in longer-term US government bonds, which have been badly hit recently.
Yield on 30-year US Treasuries (in %)
Source: FRED Economic Data (St. Louis Fed); as at 13.11.2023
Past performance is not a reliable indicator of future performance.
Expectations for US interest rates (Fed target rate probabilities, each in %)
Source: CME FedWatch Tool (CME Group); as at: 31.11.2023
Past performance is not a reliable indicator of future performance.
New fixed-income investment: Outperformance certificate on the iShares $ Treasury Bond 20+yr ETF
US government bonds under pressure
In terms of prices, there was not much to be gained in the fixed-income asset class in 2023, with quotations softening across a broad front. Given monetary policy, this weakness is generally unsurprising: the majority of central banks have been raising interest rates vigorously to ward off the spectre of inflation. Furthermore, bond markets have recently also been generating some momentum of their own. This is particularly true for the USA, because it is known that the Fed suspended the series of interest rate hikes in September. Despite the pause, however, yields continued to rise while US government bonds declined sharply. That also and especially applied for the longer terms. This thesis can be illustrated by the ICE U.S. Treasury 20+ Year Bond Index: from 20 September, the date of the Fed meeting, this benchmark lost more than a tenth of its value within the space of a month.
Possible turnaround in interest rates
It is possible that even the US monetary authorities were not entirely comfortable with the rise in yields associated with this price trend. At any rate, a rumour that the Fed could intervene in the market for US government bonds has since done the rounds. What is certain is that prices have recovered somewhat, with the ICE U.S. Treasury 20+ Year Bond Index climbing by up to 8% from its recent low. One reason for the rebound could be the strengthening consensus on a possible turnaround in interest rates next year. Futures markets are now pricing in a reduction of 75 basis points in the Fed target rate for 2024. This expectation naturally depends first and foremost on the further course of inflation and the general economic climate. Another factor is the national budget: the parties in Washington D.C. have until 17 November to amend the “stopgap bill”. If the House of Representatives and the Senate are unable to agree on interim financing, a shutdown looms. Government coming to a halt, and the unforeseeable consequences for the world's largest economy, could in turn undermine the scenario of falling interest rates.
Bond ETF as an underlying
Leonteq has launched an interesting new issue for investors who are thinking about taking a position in US government bonds in light of this background: the outperformance certificate on the iShares $ Treasury Bond 20+yr UCITS ETF. The underlying of this structured product is an exchange traded fund (ETF) on the bond index already mentioned. This currently contains 40 US government bonds with a duration of 20 years or more. A good half of the fund portfolio is allocated to US Treasuries due in 2050 or later. iShares launched this ETF at the start of 2015. The assets under management now amount to USDbn 7.42. The new outperformance certificate offers the prospect of participating disproportionately in rising quotations for the underlying.
Opportunity for outperformance
The certificate has a two-year term. Should the countermovement of the longer-dated Treasuries prove to be sustainable, the structured product would share in this with an outperformance rate of 140%. Assuming that the underlying appreciates by a fifth over a 24-month period, the certificate would repay 128% of the denomination. Please note that the participation does not kick in fully until the maturity date. Other factors will have an effect on the pricing during the term, including and especially how interest rates in the USA develop. There is no partial or capital protection, so the structured product would participate fully in any downward movement of the ETF. To conclude, the new outperformance certificate offers a good opportunity to take a punt on the interest rate turnaround in the USA and rising prices for long-dated Treasuries with diversification and leverage.
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