US Treasury Yields: Rebound or Reversal?

The rise in US bond yields in the past few weeks has become a recent market puzzle. The increase in US bond yields is influenced by recent US economic data, rising inflation, and also reflects the backlash effect of the market's previous excessive bets on interest rate cuts.

Since the September interest rate meeting, the rise in US bond yields has not only affected future rate cut expectations but also started to push up the US dollar. The natural question in the market is whether this round of US bond yield increase is a rebound or a reversal.

To answer this question, we still need to go back to the fundamentals of the economy. In our view, GDPNow remains the most accurate and timely indicator of the US economic fundamentals. Since the beginning of this year, the trend of the US 10-year Treasury yield and GDPNow can be described as closely aligned. However, starting around August, a "crack" appeared between the US bond yield and GDPNow, reflecting the market's conflicting views on interest rate cuts and causing self-doubt about the fundamentals.

Such concerns ultimately did not materialize at the fundamental level, but instead led to hesitation in stop-loss at the beginning of the rate hike. As the probability of Trump's re-election increased, the market began to worry that the current rate hike was just beginning. We try to explain the current market doubts from the following perspectives.

First, the "crack" between the US bond yield and GDPNow is not the first time it has occurred. The last similar situation was around March last year during the Silicon Valley bank crisis, when the market believed the US economy would soon enter a recession. However, it took the US economy about a quarter to refute this concern. From this perspective, in the fourth quarter of this year, discussions about the US economic fundamentals will remain the main topic for rate traders until the bull market in the rate market surrenders.

A bigger issue is whether this round of rate hikes means that US bond yields will enter a new upward cycle, which is more important for the 10-year US bond yield. Because although the path and extent of rate cuts are roughly determined, whether the possible increase in the 10-year US bond yield will reflect a new economic normal and a new term premium is something the market has been thinking about but has not yet realized.

If this scenario occurs, the possible conclusion is that the 2-year US bond yield is worth holding above 4%, but the fair value of the 10-year US bond yield may be at a high level that many investors have not previously considered The upward trend of US bond yields is not only influenced by recent US economic data and rising inflation, but also reflects the backlash effect of the market's previous excessive bets on interest rate cuts. In a report we released on September 12, we also pointed out that in the past 10 years, there has never been a continuous 5-month downward trend in the 10-year US bond yield, but this pattern was broken this year - the 10-year US bond yield has been declining from May to September.

Behind this seemingly exciting situation, it also represents the risk of the market trading passively in one direction.

As expected, the rebound in interest rates came unexpectedly. The rise in US bond yields since the September interest rate meeting has not only affected future rate cut expectations, but also started to push up the US dollar. The natural question in the market is whether this round of upward movement in US bond yields is a rebound or a reversal?

To answer this question, we still need to go back to the fundamentals of the economy. In our view, GDPNow remains the most accurate and timely indicator of the US economic fundamentals.

Since the beginning of this year, the trend of the 10-year US Treasury yield and GDPNow can be described as closely intertwined. However, starting from around August, the 10-year US bond yield began to decline rapidly, while GDPNow rebounded during the same period, causing a "crack" between the US bond yield and GDPNow. This also reflects the market's dual concerns about trading rate cuts on one hand, and the prevalence of rate cut trades on the other hand, leading to market worries about the fundamentals in a self-pitying manner.

Such concerns ultimately did not materialize at the fundamental level, but instead led to hesitation in stop-loss at the beginning of the interest rate hike. With the increasing probability of Trump's re-election, the market is starting to worry that the current upward trend in interest rates has just begun. Betting on Trump's defeat seems difficult at the moment, so the upward trend in interest rates seems more certain in the short term.

Setting aside event-driven impacts like the US presidential election, we attempt to explain the current market concerns from the following perspectives. Firstly, the "crack" between US bond yields and GDPNow is not unprecedented. The last time a similar situation occurred was around March last year during the Silicon Valley bank crisis, when the market believed the US economy would soon fall into recession, but it took about a quarter for the US economy to refute this concern.

From this perspective, in the fourth quarter of this year, discussions about the US economic fundamentals will remain the main topic for rate traders until the bullish surrender in the interest rate market.

Another longer-term issue is whether this round of interest rate hikes signifies that US bond yields will enter a new upward cycle, which is more important for the 10-year US bond yield. Although the path and extent of rate cuts are roughly determined, whether the possible upward movement of the 10-year US bond yield will reflect a new economic normal and a new term premium is something that the market has been thinking about but has not yet realized If this situation occurs, the possible conclusion is that the 2-year US Treasury bond yield may have holding value above 4%, but the fair value of the 10-year US Treasury bond yield may be at a high level that many investors have not previously considered.

Of course, the appearance of these issues still requires more time and data for verification. In the short term, unless there is a significant change in the Harris election situation, the upward risks of US dollar interest rates and exchange rates are indeed still accumulating.

Author: Zhou Hao (S0880123060019), Sun Yingchao, Source: Guojun Overseas Macro Research, Original Title: "Guojun International Macro: US Treasury Yields: Rebound or Reversal?"