Weakening economy supports prospects of US Treasuries
Long-dated US Treasuries are unlikely to be sold off further, given that negative factors have already been priced in
THE “One Big Beautiful Bill” has drawn widespread attention to the US fiscal situation, contributing to the removal of US’ last AAA credit rating. On top of that, the recent US Treasury auction was lacklustre. These factors weighed on the prices of US long-dated Treasuries in the second quarter of this year.
Will long-dated US Treasuries be sold off further? I think it is unlikely, given that a lot of negative factors have already been priced in.
Although fiscal conditions will affect the trend of bond yields, economic data is still the biggest determining factor. I think the inflationary pressure in the US is not as serious as some investors expect. It is worth noting that the tariffs are likely to have a one-off impact, and inflation is mainly driven by wage growth and job market conditions. As the economy slows, wages and core service prices (excluding housing) will continue to cool.
In addition, China’s deflationary trend continues, weighing on commodity prices. At present, US economic growth has shown signs of weakening, and GDP may fall below the long-term average. If the unemployment rate rises, the US Federal Reserve should cut interest rates again this year.
The market generally expects the Fed to cut interest rates twice this year – a total of more than 50 basis points. I believe that the final number of interest rate cuts may be more than what the market expects, which will support the prices of US long-term Treasuries.
US fiscal situation may not be as severe as expected
While the market understandably has doubts about US President Donald Trump’s “One Big Beautiful Bill”, investors should take a more comprehensive view when examining the US fiscal situation.
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Even if he makes some concessions on tariff policy, the tariff will definitely not fall back to the pre-Liberation Day level of 2 to 3 per cent; rather, it would land in the range of 8 to 9 per cent – enough to bring US$250 billion to US$300 billion in fiscal revenue, which is almost equivalent to the annual expenditure of the “One Big Beautiful Bill”. Therefore, the US fiscal problem may not be as bad as the market expects.
In addition to the Treasury market, the market is also concerned about the erosion of US dollar’s role as an international reserve currency. We have reservations about the performance of the US dollar, so we have been reducing our holdings of US dollar assets.
But this is not because we are worried that the US dollar will lose its store-of-value function. After all, what alternatives do sovereign wealth funds and major central banks have, apart from gold or AAA-rated Treasuries like those of Australia?
Moreover, the liquidity and market size of these assets are not on the same level as US Treasuries, so it is simply unrealistic for them to completely withdraw from the US Treasury bond market.
In contrast, the risk of outflow from US dollar assets is more worthy of attention. In the past few years, US stocks have been heavily sought after, and investors’ positions in the US market have been approaching the limit.
The chaos created by the Trump administration is prompting global investors to rethink their overall asset allocation, which might mean reducing their holdings of US assets, hedging against US exchange-rate risks, or switching to other markets. All these will create downward pressure on the US dollar.
Inflation-protected bonds and MBS attractive
For a good part of the past two decades, major central banks have implemented quantitative easing policies, which have suppressed the volatility of the bond market and taken away obvious investment opportunities from the market.
However, now that market volatility has increased again, active managers are set to benefit from more opportunities. Therefore, for active investors like us, this is actually good timing.
We currently favour long-dated Treasuries and inflation-protected bonds (including Tips in the US and inflation-linked bonds in the UK). If we are wrong about the interest rate curve, the most likely reason is that inflation is higher than expected. If so, inflation-protected bonds will outperform regular bonds because interest rates may rise due to rising inflation.
In addition, we are also positive about US agency mortgage-backed securities (MBS). These are backed by the US government and more secure than non-agency MBS. Market volatility is pushing up the spread of MBS. The yield of recently issued MBS ranges from 5.5 to 6 per cent, which shows investment value.
Meanwhile, some local sovereign bonds in emerging markets also have high yields, and are worth investors’ attention.
The writer is head of global aggregate and absolute return, BNP Paribas Asset Management
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