Investors Eyeing Long Treasury Bonds as U.S. Economy Shows Signs of Revival

Investors Eyeing Long Treasury Bonds as U.S. Economy Shows Signs of Revival

Investors who are doubtful about a smooth and gradual slowdown of the U.S. economy are considering the option of purchasing long Treasury bonds. Despite the Federal Reserve Bank already implementing the highest interest rates in over two decades, the economy seems poised to pick up speed. The Federal Reserve Bank of Atlanta predicts a gross domestic product growth rate of 5.9% for the third quarter.

Although some market participants believe in a "soft landing" for the economy, experts like John Madziyire, senior portfolio manager at Vanguard Fixed Income Group, view it as a transitional phase rather than a final outcome. Madziyire highlights that the current market environment factors in a positive scenario with sustained growth, which aligns with the Federal Reserve's objectives.

Madziyire also voices concerns about the strength of the labor market and believes that economic growth must decelerate in order for the Federal Reserve to achieve its target inflation rate of 2%. He predicts that the economy will not avoid a softer landing forever and expects a pivotal moment to arrive.

Focus on Labor and Growth

This pivotal moment may involve the Federal Reserve taking more aggressive measures to combat inflation or economic indicators gradually cooling down as a result of previous interest rate hikes. Fed Chairman Jerome Powell addressed these possibilities in his recent speech in Jackson Hole, Wyoming, acknowledging that reaching the inflation target would require some periods of below-trend economic growth and a moderation in labor-market conditions.

In a note published on Monday, Mizuho Securities' U.S. economists commented on Powell's speech, emphasizing that the Fed could further increase interest rates to mitigate any potential inflation risks stemming from robust economic growth or excessively strong labor-market data.

Investors are now closely monitoring the upcoming inflation data set to be released on Thursday, as well as Friday's jobs report for August, in search of clues that could indicate whether the Federal Reserve will choose to increase or maintain interest rates within a range of 5.25% to 5.5% in September.

While higher borrowing rates can pose a threat to corporate growth and subsequently impact equity prices, they serve as a source of income for investors when it comes to higher bond yields.

A Volatile August

August was a tumultuous month for the Treasury market, as the 10-year Treasury yield (BX:TMUBMUSD10Y) surged above 4.3%, reaching its highest level since 2007. This increase in yield, coupled with Fitch Ratings' downgrade of the U.S. from AAA to AA+, and the Treasury Department's announcement of a $1 trillion borrowing need for the third quarter, contributed to a significant selloff. It's important to note that bond prices move in the opposite direction of yields.

While the 10-year Treasury rate eased back to 4.2% on Monday and the 30-year Treasury rate (BX:TMUBMUSD30Y) stood at 4.28%, higher long-term rates have already resulted in increased borrowing costs across various sectors of the economy. For example, the average 30-year fixed mortgage rate has risen to 7.23%, the highest it's been since 2001.

Despite these recent developments, the LPL Research team recommends a modest overweight to fixed income funded from cash. They anticipate that the 10-year Treasury yield will average around 4% for the next decade, which is in line with the average yield before the global financial crisis.

In the early 2000s, the Bloomberg Aggregate Bond Index (AGG) produced an average annual return of around 6%. Although higher starting Treasury yields may impact fixed-income returns, LPL's Lawrence Gillum, chief fixed-income strategist, and Jeffrey Roach, chief economist, believe that this could translate to higher overall returns.

Given the higher yields, Vanguard's Madziyire predicts that pension funds and other institutional investors who were sidelined by recent turbulence in the Treasury market will likely return as buyers.

Even amidst these market fluctuations, stocks ended on a positive note on Monday, with gains seen in the S&P 500 (SPX), Dow Jones Industrial Average (DJIA), and Nasdaq Composite (COMP).

Read: Pimco emerges as a buyer in Treasury market selloff, says Bond Vigilante theme 'a bit extreme'