Top of the Morning: CIO Strategy Snapshot - Implications of higher rates
The desk interprets the ongoing rise in U.S. treasury yields as a significant market driver that could influence FX dynamics, particularly for the USD. Per the full note , Jason Draho of UBS highlighted recent positive economic data, including a surprising uptick in global PMI manufacturing indices, which is contributing to this yield increase. With the 10-year yields climbing approximately 55 basis points since late August, the implications for currency valuations are noteworthy. This move suggests that traders should carefully monitor U.S. economic indicators, particularly with the upcoming payrolls report that may further inform market expectations.
What the desk is arguing
The current trajectory of U.S. treasury yields is sharpening the focus on currency valuation, especially regarding the dollar's strength. Jason Draho emphasizes the surprising strength in PMI manufacturing data, both domestically and abroad, which has further fueled the rise in yields and reflected positively on investor sentiment.
The rise in the 10-year treasury yields, recently reported to be up about 20 basis points last week alone, signals an evolving economic landscape that traders must navigate carefully. As yields continue to soar, this trend could lead to a stronger USD against a basket of currencies, especially if labor market data supports growth narratives.
Where it sits in our coverage
Our consensus target for USD performance currently rests at 1.075, aligned with jpmorgan's projection of 1.10 for Mar26. Notably, bofa proposes a more conservative target of 1.04 for the same tenor, indicating a divergence in expectations among analysts. Given this landscape, our desk's view aligns closely with the higher forecasts within the upper target range.
How other firms see it
Aligned views are found among firms like jpmorgan and goldman who forecast stronger USD performance, bolstered by anticipated economic resilience. Conversely, bofa holds a contrary stance, suggesting weaker USD prospects contrary to prevailing market trends. Focus on trading pairs such as USD/EUR could reveal tensions stemming from differing central bank policies and economic outlooks.
01U.S. treasury yields rise are driven by positive economic data, impacting FX markets.
0210-year yields are up approximately 55 basis points since late August, indicating potential dollar strength.
03The strong PMI manufacturing indices suggest economic resilience, which could further support the USD.
04Divergence in institutional forecasts highlights varied outlooks for USD strength moving forward.
Market implications
Traders should closely monitor key labor market data, particularly the upcoming payrolls report and how it influences treasury yields and USD valuations. A continued rise in yields could set a new range for major currency pairs involving the USD.
Risks to this view
A significant downturn in upcoming labor market indicators or a bearish reversal in economic sentiment could undermine the thesis of sustained USD strength and lead to a sharp correction in yield expectations. Additionally, geopolitical events or monetary policy shifts from other central banks could also derail current trajectories.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. The main market story continues to be the rise in treasury yields, why they're rising and how high they could go.
But there are other stories occupying investors' attention, including the outlook for oil prices and new developments in agentic AI. Joining me here on this Monday morning to talk about this all, glad to have with me for the CIO Strategy Snapshot, Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office within UBS FSI. Jason, good Monday morning to you.
Welcome back and hope you enjoyed a nice weekend. Thanks, Dan. Good to be here.
Happy Monday. Let's begin with the rise in rates, which did continue last week. In your view, what's driving rates higher?
Well, if we just take what happened last week, you know, the 10-year treasury yields as our main point, it was up about 20 basis points last week. Now, if we go back to roughly the end of August when Fed Chair Kevin Walsh gave a speech at Jackson Hole right before that, you know, from right before that to now, the 10-year yields up about 55 basis points and the entire yield curve has risen dramatically, even more so at the front of the curve. I mean, the two years have gone even higher than this.
So the real question is, like, why the rates rise and why even last week, like, another leg higher? I did see a mix of different factors participating. One is that there was another round of good economic data last week.
PMI manufacturing indices surprised the upside, not only in the U.S., but globally. This is not normally a widely followed or impactful data point for the markets, but it was strong data that's added to other strong data recently. There were also details within the U.S. report that suggested real strength on the labor market.
On Friday, we get the September payrolls report. The PMI data would indicate or suggest perhaps that the number could be strong again, unemployment rate could drop. So, you know, good data there reinforcing a positive momentum.
There were many Fed speakers from the FOMC who were, you know, last week talking about their views. It was a very consistent message, you know, all suggesting that the rates need to go higher to, you know, to bring down inflation. Sometimes there are some officials who can be perceived as a little more on the dovish end.
Even those ones, like someone like a New York Fed president, John Williams, you know, we can reiterate this relatively hawkish message. And then oil prices, you know, have been a factor driving yields higher. Last week they declined a little bit, but that's been a factor in the background driving rates higher, particularly at the back end of the curve, like the 30-year point and beyond.
As a result of all this, you know, the market is now pricing for about a 60 or like one or two-thirds chance of a hike in the October FOMC meeting, 1.5 hikes by the end of December and a cumulative total of almost four hikes over the next year. So just rate expectations going higher leaves the market also pushing yields up across the board. And the final factor that's been driving rates higher is as they've risen, they've risen really dramatically.
There is certainly a reluctance amongst some investors who might be typical buyers of treasuries because they've stepped in, you know, the proverbial catch-a-fall-in-the-net, they don't want to do that. So you're seeing the lack of buyers, but also of investors who are short, systematic strategies like momentum strategies, CTAs, very short treasuries. The data on, you know, flows in futures markets for, you know, kind of shorter term, intermediate term treasuries was very negative, a lot of selling activity.
So people are short and that sort of, you know, investors aren't stepping in to buy. That leads us to a technical dynamic that kind of exacerbates some of these fundamental factors. And all that combined is pushing yields higher.
With that, Jason, how much higher do you think rates could realistically go? Well, in the short term, there's always a chance of what's called a technical overshoot. If investors aren't willing to step in and buy, there could be a single data point that can cause yields to go higher.
And without that sort of bid to buy, you know, the 10-year could, you know, wouldn't be shocking if it got to 5.5%. We're already at 5.2%, so not a, you know, a big move from here. To be able to stay there and not sort of revert back to 5.2%, you know, within a matter of days or a week or two, it really has to be a fundamental difference of view from investors of the state of the economy and what is the economy capable of sustaining indefinitely.
What we've seen is the 10-year yield has moved almost in parallel with the market expectations for where the Fed funds rate will be at the end of 2027. And so in order for the 10-year to go higher, the market has to expect even further hikes, you know, maybe a total of, you know, four hikes or more, essentially undoing all the cuts that took place after the Fed, you know, raised rates to over, you know, 5.25%. So kind of getting back to that level, but then also thinking that this is a sustainable level, like the neutral rate for the Fed fund rate is 4.5% to 5%.
The economy is growing very strongly, like an abnormal GDP of 6%. All that would suggest that, well, a 10-year at 5.5% won't, you know, do significant damage to the economy. So it's not just a matter of overshooting, but you have to fundamentally think of this as a different macro regime going forward.
A more likely scenario, the default scenario for investors is that if market expectations for Fed rate hikes keep going higher because the economy is strong, concerns about overheating, you know, persist, then the concern that investors would have is as the Fed has to hike, it has to do so such that it would need to slow the economy down, you know, raise the risk of recession. Then you start to see the yield curve continue to flatten out and potentially invert as what happens once the economy starts to cool down, oh, then the Fed has to cut significantly in order to, you know, try to revive the economy. So there is this sort of cap on how high the 10-year can go unless you believe growing at a 6% normal GDP rate will persist indefinitely.
Otherwise, I think you start to see the market believing the Fed's going to hike, ultimately going to have to trigger a recession or some significant slowdown. Otherwise, I think it's harder for the 10-year to sustain, say, sustainably above the current level, you know, overall. In terms of how this is impacting the economy, Jason, what is the impact of higher rates and are they a headwind or perhaps a consequence of a strong economy?
Well, all is equal if you kind of use a Fed sort of macro growth model. If you assume yields are 50 basis points higher sustainably across the entire yield curve, what that would do is probably reduce growth over the next year by about 20 basis points relative to your baseline estimate. So instead of, say, growing at 2.1%, you grow at 1.9%.
You're not dramatically different. The reason for this is that there are many parts of the economy that are not particularly interest rate sensitive. You know, the EIPEC spend that's going on, unlikely to be impacted by its 50 basis point higher in rates.
Upper income households, you know, they're not overly sensitive to higher rates. If anything, the amount of money they can get on their cash savings goes up, so it almost gets up for them to almost be negative to positive. Meanwhile, the more kind of rate sensitive, cyclical parts of the economy, like housing, are already relatively weak, so it's not like they can weaken significantly from here.
So I think that the overall bottom line is that the move higher in rates that we've seen thus far, not a major change for the macro outlook. We really do see a significant tightening of financial conditions, which means not only rates go higher, but equity prices fall, credit spreads widen, that kind of starts to actually materially slow down the economy overall. Which does beg the question, as you mentioned, you know, are higher rates actually a consequence of good growth?
I allude to the fact that, you know, in order for the 10-year to stay sustainably above the current level, you need to have a perception that the economy is going to continue to grow at 6% nominal GDP. That was how fast it grew in the first half of the year, in fact it's more than 6%. Tracking for Q3, and we're almost on the quarter, would suggest that nominal GDP will again be, you know, around 6% or higher.
You know, kind of a basic rule of thumb is that over the long term, the nominal 10-year treasury yield shouldn't be that much different than nominal GDP growth to kind of keep things in equilibrium. So if we're going to have an economy that's growing 6% nominal GDP, it's not surprising that you should have a 10-year treasury yield over 5% approaching, you know, 5.5%, you know, percent. It really just, again, gets back to the question, like, is this level of growth rate, you know, sustainable?
And that, you know, probably not. None of these levels, some moderation is likely, but that suggests that some of the rate move was really more sort of wealthier result, U.S. economy, rather than it being a major headwind for growth going forward. In terms of positioning, Jason, for investors, how should they position at the moment within fixed income?
Well, as rates have risen, it sort of played out, you know, one of our risk scenarios where we thought with rates rise, you're going to obviously get, you know, hit from longer duration bonds. It was a key reason why our recommendation for much of the spring and the summer was to keep, you know, kind of maturity exposure in fixed income relatively short, going up maybe to about the five-year point on treasuries, and sticking with higher quality. As rates have risen, you know, yields have become more attractive.
Also the risk-reward starts to become more interesting, because as I mentioned, you know, the possibility of the senior going higher exists, but there's limits to how high the level likely could go, and make something to go a lot lower. And now you get the benefit of kind of an asymmetry where if rates go higher, they start to impact some of your total return from prices going higher, but you still get attractive income. If yields stay where they are, well, now you're getting over a 5% yield over the next year on a 10-year treasury, and if the change were to fall back to 55 basis points or even more, you could be looking at a close like a 10% return over the next year for buying treasuries.
So the risk-reward starts to look, you know, more attractive, which is why we're suggesting, you know, incrementally extend the duration a little bit, target up towards maybe a seven to eight-year point of maturity. Still be cautious on the very kind of longer maturity bonds, but it's becoming a more interesting kind of risk-reward trade-off. But the overall message is still just to kind of stay up in quality.
You don't need to take a lot of risk right now to get yield, and if you give them what interest rates are, a little bit more attractive way to do it is adding some of that interest rate exposure. Jason, that's interesting. If fixed income is becoming marginally more attractive, does that make equities relatively less attractive?
I'd say the short answer is no, and if you judge by market performance, other investors agree with me. You know, in the last week, the Nasdaq, you know, had an all-time high. The S&P 500 is only 1% away from its all-time high, and this is despite, you know, oil prices are going higher, but despite, you know, the significant rise in interest rates, you know, if you look at a basic relationship, you know, earlier this year between the S&P 500 and the 10-year Treasury, the 55-basin point rise in the 10-year yield over the past roughly month would, based on this part of the relationship, suggest the S&P should actually be about three percentage points lower than it is right now, so the S&P is outperforming, you know, equities are outperforming, you know, given the movement of rates, which suggests there's other factors, good growth, you know, that are kind of driving things higher.
You know, it's also the S&P is outperforming, you know, how it would normally do relative to the rise in oil prices, again, suggesting some resilience. All this is kind of pointed to both good macro conditions, like from a nominal GDP growth perspective, because if you're going to grow nominal GDP at 6%, you know, top-line revenue growth for S&P 500 companies should be at least 6% if not higher. That translates into higher earnings growth, but a key driver in all this, of course, is the kind of AI theme that can be used to play out into the secular theme that it's not completely impervious to the macro conditions and rates, but, you know, relatively immune to the move we've seen in rates thus far.
There continue to be developments that reinforce the, you know, potential, you know, benefit from AI, from agentic AI, you know, last week at Meta launched Muse, a new agentic AI application for individuals, that certainly boosted their stock price, but it's also kind of reinforced the kind of AI theme, you know, overall. So the performance and appeal of equities is not just a macro story, which is a tailwind for it, in our view, over the next year, but the AI investment thesis could use to be probably the biggest key driver for equity markets, and that's not particularly rate-sensitive. So you add it all up, you know, will bonds become relatively more interesting?
On an absolute basis, equities still seem, you know, definitely look more attractive to us at this point in time. Jason, very timely insights, given what we've seen in rates over the past couple of weeks and understanding how this has been impacting the broader markets and how you should think about positioning accordingly. So Jason, thank you again for dropping by on this Monday morning for The Snapshot, and I do look forward to picking back up with our conversation in the week ahead.
You're welcome. Have a great week. You as well.
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