August Outlook
August 10, 2023  |  By Hank Cunningham

Inflation remains at the forefront of factors influencing bond yields and there is little doubt that it has crested globally. After two relatively mild CPI prints in the U.S., the market believes the Fed will pause in September but will likely hike again in November. Fed Chair Powell is on record saying he would like to see several encouraging inflation reports before reconsidering the Fed’s monetary stance. However, the factors that contributed to the recent increase in yields are likely to prevent market yields from retracing lower. Such factors include the resilient economy, the $2.3 trillion annual borrowing requirement by the U.S. Government, the Bank of Japan’s move to tighten, buoyant consumer confidence, and ongoing firmness in the important employment and housing sectors. Moreover, the Bank of Japan’s decision to allow their 10-year bonds to move another 50 basis points higher, towards 1%, may cause Japanese investors to repatriate some of their foreign holdings, thereby putting upward pressure on bond yields. They own more than $1 trillion worth of U.S. Treasuries.

The strength in corporate bond markets and the accompanying tightening of yield spreads with government bonds argues against a recession this year. Thus, bond yields could challenge 4.25% again in the U.S. 10-year maturity. Rallies are possible, which could bring their yield down to 3.5%. Interestingly, the latest rise in the 10-year note was not matched by the movement in two-year yields. The yield curve is now less inverted by 25 basis points and this trend should continue.

Also of important note, the recent decline in the inflation rate, combined with the rise in interest rates and bond yields, has produced something not seen in years – positive real yields! The Fed Funds Rate at 5.5%, is now decidedly punitive. Investors can earn a pre-tax real yield and borrowers are incurring a real cost of funds.

Fixed income investors have earned meager returns this year. As measured by the FTSE Bond Universe Index, year-to-date returns have been just over 1%. Corporate bonds have returned more than double that. For the remainder of the year, fixed income investors will likely realize positive, but modest returns.

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