Keep bond duration short; rates may remain higher for longer
With the US labour market as well as core inflation remaining resilient, the Fed may not cut interest rates as widely expected
NOVEMBER kicked off with a flurry of events, starting with the US elections, where Donald Trump and the Republican Party secured a decisive victory with the presidency and majorities in both houses of Congress. Later in the week, the US Federal Reserve delivered a widely anticipated 25 basis point rate cut in a unanimous decision.
The Fed struck a slightly more positive tone on the labour market in its November meeting document compared with that in September, with unemployment “edging down” over the past three months. On the other hand, it indicated caution on inflation, with the removal of the phrase “greater confidence” regarding inflation moving towards 2 per cent. Broadly speaking, however, we think the main takeaway was the Fed’s reiteration of a data-dependent approach moving ahead.
We adopt a similar data-dependent approach in determining our interest rate expectations. Labour market indicators such as wage growth and unemployment rate have normalised to pre-Covid levels, but do not show signs of a severe labour market downturn.
Meanwhile, inflation remains persistently above the 2 per cent level (October consumer price index inflation at 2.6 per cent), and long-term inflation expectations have also climbed away from the 2 per cent level, observed through either five-year inflation swaps (2.5 per cent) or 10-year break-evens (2.3 per cent). The data is as at Nov 15.
Looking ahead, we expect a higher-for-longer rates environment, anchored by a resilient labour market as well as core inflation, which we expect to remain above 2 per cent. This is a view we have held since the start of this year; we previously said that markets were overly optimistic in pricing in six rate cuts by the end of 2024. We have been right so far, with the Fed poised to deliver just three to four cuts for the year.
Specifically on inflation, Fed chairman Jerome Powell has recently acknowledged that the descent of inflation could be “sometimes bumpy”. Over the longer term, we highlight various upside risks, including deglobalisation affecting supply chains (including potential tariffs) and risks arising from a green transition.
Tariffs – a policy focus for Trump on the campaign trail – could also rekindle inflation depending on the scale and extent of tariffs; this supports the case for rates staying elevated. Trump will also face questions on the sustainability of the US fiscal debt especially if his proposed tax cuts are implemented, which could affect supply-demand dynamics for US Treasuries and potentially push long-end yields up higher.
Short and sweet
Our expectations for a higher-for-longer rates environment anchor our preference for shorter-duration fixed-income products, due to their lower sensitivity to interest rate fluctuations, amid Fed-cut expectations that we still deem aggressive. Investors are likely to see less volatility in the mark-to-market value of their shorter-duration fixed-income holdings, and less mark-to-market price losses if interest rates (or interest rate expectations) increase.
Another big contributing factor to our view is the inverted yield curve in both Singapore and the United States. In other words, investors are getting higher yields for Treasuries at the six-month tenor (an example of short duration), compared with those at the 10-year tenor (an example of long duration). We think investors are insufficiently compensated for the higher maturity and duration risks of long-tenor bonds; instead, we would prefer to wait for the curve to normalise into a typical upward-sloping shape before considering adding on duration.
It is also important to emphasise that long-duration bond yields may not necessarily drop alongside rate cuts, as rate expectations remain very aggressive. This is evident so far this year, as 10-year US Treasury (UST) yields have actually increased both year to date, as well as from the date of the first Fed cut (Sep 18).
If you had invested in a benchmark 10-year UST bond (maturing in November 2033) at the start of the year, you would be slightly in the red as at Nov 15, with the 4.5 per cent (annualised) coupon mitigating its price decline. This once again underscores the need to consider the shape of the yield curve, rather than simply adding duration due to the high likelihood of rate cuts.
To summarise, we think a higher-for-longer rate environment and the still-inverted yield curve today justify our preference for shorter-maturity and shorter-duration products. We believe attractive fixed-income opportunities are on the shorter end currently, particularly in the one-year tenor where the highest nominal yields are to be found on the Treasuries curves in Singapore and the US.
The writer is a senior analyst in the Bondsupermart team at iFast Financial, the Singapore subsidiary of Singapore Exchange-listed iFast Corporation
