Top of the Morning: CIO Strategy Snapshot - Policy Endgame
The desk anticipates that higher interest rates will influence currency markets, particularly as investment focuses on potential policy responses from central banks. Per the full note source, the surge in U.S. Treasury yields, particularly those at the long end of the curve, has drawn the attention of traders, with the 30-year yield recently peaking at 5.3%, the highest since 2007. This environment sets the stage for increased volatility and potential revaluations across various currency pairs, particularly against a backdrop of changing monetary policy expectations.
What the desk is arguing
The desk believes that the current trajectory of Treasury yields will lead to significant implications for currency valuations, notably as investors react to potential Fed policy adjustments. Per the full note source, the shift in Fed communication aligns with rising yields, especially at the back end of the curve, signaling a potential regime change in interest rate expectations.
As yields have risen sharply, notably from below 5% earlier this summer to 5.3% in late August, it reflects a broader sentiment shift among investors and could impact capital flows significantly. The desk's interpretation hinges on the ability of yields to sustain above these levels, which could prompt a reassessment of dollar-denominated assets.
Where it sits in our coverage
With no specific internal coverage for relevant currency pairs, we note that expectations for a stronger U.S. dollar may gain momentum based on current yield trends. Analysts suggest that the dollar's strength appears reinforced by rising interest rates, particularly following recent Policy Committee communications.
How other firms see it
Analysts at jpmorgan, with a target of 1.10 for the euro against the dollar by March 2026, are aligned with this view, suggesting expectations for a stronger dollar amidst rising rates. In contrast, bofa holds a contrary position, targeting a weaker view at 1.04. Given these positions, the euro-dollar dynamic may reflect differing confidence in recovery trajectories and inflation management.
What the calendar says
There are no upcoming high-impact events scheduled in the next month that will influence this narrative significantly, indicating that market participants may continue to react to yield changes and Fed commentary absent specific data releases.
04Future Fed communications will be pivotal in shaping market sentiment.
Market implications
Investors should closely monitor the 30-year Treasury yield, currently at 5.3%, as a key indicator of market sentiment. Additionally, potential volatility in the EUR/USD pair may arise as traders reassess Fed communications in relation to rate trajectories.
Risks to this view
A reversal in the yield outlook, particularly a drop below 5% in the 30-year Treasury yield, could indicate weakening interest rate expectations and thus undermine the dollar's strength. Furthermore, any unexpected dovish shifts from the Fed could trigger a swift revaluation across currency markets.
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Hi everyone, Dan Cassidy here. Welcome back to top of the morning on the UBS Market Moves podcast channel. Higher interest rates and government finances have been in the spotlight over the past week with investor attention focused on possible policy responses this week and beyond.
The markets have been struck by these developments, but have remained resilient as the summer nears an end. So joining me here today at the 1285 podcast studio in New York, glad to welcome back from UBS, FSI, the UBS chief investment office, head of asset allocation for the Americas, Jason Draho. Jason, good Tuesday morning to you and great to be back with you here at the table.
Happy Tuesday, Dan. Good to be here. So Jason, let's get right into it.
Let's begin with the rise in treasury yields, which investors have noticed a lot in recent days. What have been some factors out there causing this rise and what is necessary for yields to decline at this point? Well, the rise in yields we're talking about are at the back end of the curve, particularly the 30-year treasury.
It reached 5.3% about a week ago. This is the highest level since 2007. Other treasury yields have not risen as much.
For example, the 10-year got up to about 4.75%. It did get up to 5% a few years ago. So it's really kind of the back end of the curve.
That was sort of the most noteworthy thing. So the question is what's causing these rise in rates? And there's multiple factors one can point to.
For example, we've had a sort of a change in Fed leadership and communication over the past couple of months. That is something relatively new. And the rate rise, and particularly in the 30-year just for context, it was below 5% for most of the second quarter.
So this rise has really materialized in July and particularly kind of for end of July into late August. A lot of it happening after the FOMC meeting on July 29th. So the Fed change in leadership and communication has been a factor.
There's just increasing demand for capital from the private sector with the AI build-out, both debt issuance, equity issuance. So you essentially have like competition for capital that's going to bid up yields as essentially bond prices go lower. During the summer, we had at least at the end of June a signed memorandum between the US and Iran that was bringing down oil prices.
That didn't last particularly long. And now we've seen oil prices kind of rise again that sort of fuels some inflation expectations. These are all kind of I'd say newer developments in the past couple of months.
In the course of trying to explain why the rates rose, other people pointed to the fact that you have a large government deficit that's still running 6%. This is true. And large deficits at the margin, they are a factor in causing yields to be higher.
I would say that's not new information. We've known this is a problem for a while. The market shouldn't suddenly have to price that in a short-term basis.
And some of these kind of supply side problems, whether it's high oil prices or other factors, I mean, this seems to be just a reality of the global economy nowadays. So the idea that there'll be supply disruptions that are inflationary, that should sometimes be baked into a long-term inflation risk premium for bonds. So again, not really new information.
So I think to me, the key things is the change in the Fed communication, this just competition for capital, and then some inflation aspect related to the oil prices. So that's what's really kind of caused the rise. In terms of what could cause it to go lower, obviously a change in the inflation outlook.
So we got good inflation data for July, at least in line with expectations. If the August data and then sort of the next couple of months after that are relatively benign, similar to what they were in July, you'll see a more clear disinflation trend. I think that would allow the Fed to sit on hold in September, not raise rates in September.
The rate hikes that the markets are currently pricing in, and still about 1.7 hikes over the next 12 months, those are to kind of get priced out. So it's less than one full hike priced in. You can see certainly shorter maturity yields, like the two-year, the five-year go lower, but likely it's going to sort of bring down the whole curve to some extent.
Maybe not to quite those levels below 5% for the third year, but I think that's probably the number one catalyst in the near term that can get yields to go lower. The related story to the rise in yields is the Treasury making a surprise announcement to more than double the size of their buyback program. We heard recently from Treasury Secretary Scott Besant.
What exactly does this strategy entail? So what the Treasury can do, and it started to do a couple of years ago, is some form of essentially kind of altering the supply of Treasuries outstanding in the market. So there's a regular sort of funding requirements for the government issuing different maturity structures from T-bills of three months to two years, five years, 10 years, and sometimes 30-year Treasuries.
On a quarterly basis, the Treasury will reannounce its refunding intentions, meaning like how much it's going to issue, the supply, the composition, and they deal with sort of clear guidance meant to be sort of predictable so the markets and investors can anticipate this. They do it on a somewhat regular schedule like beginning of August or beginning of November. What they did a couple of years ago is also announced that what they'll do is buy back longer maturity Treasuries because what's happened is Treasury yields have risen.
The bond price is like for 30-year yields have fallen a lot. So simple thing is you can imagine a 30-year Treasury bond that was issued in 2020 when rates were incredibly low as the 30 years gone from 1.5% to almost 5.5%. That price of that bond could have fallen essentially like from $1 to $0.77, something like that.
So the Treasury is going to step in, buy those bonds. Now they still need to fund the government so they issue shorter maturity bonds, but the idea is by stepping in, you effectively can try and provide a bid to those bonds and therefore lower the prices because if you provide a floor, it kind of means that prices can't go lower, interest rates can't go higher. What the Treasury did last Wednesday is put an announcement surprisingly to say that they're going to more than double the size of their buyback of longer term Treasuries, meaning like 10 to 30-year Treasuries.
They're doing roughly $2 billion a month. They could double that to more than $4 billion. It was scoped for even higher numbers.
So that was the announcement and then sort of explaining it to Treasury Secretary Scott Besant did say that he didn't think that those yields reflected economic fundamentals. Part of this was an effort to sort of step in and intervene. The market verdict initially was yields to go lower, the 30-year fell about nine basis points, but by the end of the week, it sort of almost fully retraced that and was back up to only one basis point lower than when the announcement occurred.
Since then, there's been pretty widespread sort of criticism just like across Wall Street of this approach, what the Treasury is trying to do. But that was sort of the actions, that's the motivation of what the Treasury was intending. To tie in your latest blog, the title, Policy Endgame, which by the way, for our listeners, our clients, is available now up on UBS.com slash CIO.
Jason, within the blog, you suggest that policymakers want yields to decline, but they face two challenges. What are policymakers up against? Well, one of the challenges is to be able to clearly communicate and implement consistent policy.
That's one challenge. And the other is that the federal deficit and the debt problem is literally growing every day. So on the first one, the communication problem is that, look, they can control it.
They can improve the communication. The debt sustainability is an elected official issue. There's only so much that – Some $40 trillion. $40 trillion that we've surpassed but ultimately requires legislative action.
There's only so much that the Treasury Secretary can do through these kind of measures of altering the supply of types of treasuries. On the communication front, there's a couple aspects to this. One is that Kevin Walsh, as the Fed Chair, has now had two press conferences.
He's chosen to not provide forward guidance. He does not believe in providing forward guidance. And by that, I mean indicating to the markets and investors where Fed policy could be headed.
Suggesting, for example, we think policy is in a good place and therefore we don't want to raise rates or something along those lines, but kind of tipping their hand of where they intend policy to go. Walsh does not believe in that. He thinks the market should sort of interpret the economic data itself, produce the information and then sort of send the signals back to the Fed that way versus the Fed signaling what it's going to do and the market sort of pricing that in.
That would be sort of perhaps a reasonable approach. But Walsh has also chosen not to provide any real information like what's the policy framework of like how they would even consider it, like what inflation data, what data points are they considering, what are the sort of criteria. So – We'll have to figure out.
So it's a little bit of – we don't know what the data is going to – I mean they could say like we don't know the data is going to be, but if the data is X, Y and Z, here's our policy framework and that would kind of give indication the markets can make their own assessment. He hasn't even sort of provided that. And as an explanation at the July FOMC meeting, the press conference afterward as to why they didn't raise rates, despite fairly hawkish rhetoric from himself and others on the committee, left investors sort of unsatisfied, like kind of not providing a clear, consistent framework.
So you can see so far it's been a communication disappointment at a minimum, if not more. So that's one issue. He does, Walsh, have an opportunity to help clarify some of this on Friday.
This is August 28th. There is a central bank symposium in Jackson Hole, Wyoming. It's always the case that the Fed chair gets sort of the keynote speech on Friday at 10 a.m. eastern time.
It's already been reported in the media that he will sort of address some of these issues, how much he says, what he says, you know, at least in terms of a framework remains to be seen. Given sort of the expectations that he would do something, I think the bar has actually gone high for him to sort of actually clarify it. If it's against sort of generalities, the market again could be disappointed.
But that's one thing where they can help communicate. The Treasury now, by intervening in the market and also doing it in a way that sort of left investors unsatisfied with the explanation, the rationale, sort of not being viewed credible, doesn't help matters. On the communication front is that Warsh has basically said, you know, we want the bond markets and financial markets to produce the signals.
We don't want them to take the lead from us and then we will kind of draw that information. By the Treasury, by intervening in the long duration market, they're actually trying to manipulate those prices, saying the prices are wrong, completely at odds, 100% different than what the Fed wants. So it doesn't help investors to look at this and say, well, we have conflicting messages and approaches from the Federal Reserve and the Treasury Department.
That just doesn't give us necessarily a lot of confidence. So this communication challenge in some sense is self-inflicted, but they have to kind of resolve this and at least give investors more comfort that there's a clear, consistent policy of how they're approaching this. The other one I mentioned is the debt problem, the $40 trillion that's now standing, deficits that are running at 6% of GDP.
The interest on the debt is now over $1 trillion and by next year it will be the single biggest outlay. None of this is particularly good. There's only so much, again, like I mentioned, that the Fed can do or the Treasury Secretary can do.
It's ultimately up to Congress to pass legislation to resolve this. There doesn't seem to be much political appetite in Washington, among other parties, to address this. It's unlikely anything is going to happen before the midterms and I think it's still pretty low odds that something is going to happen before the next general election.
So we're looking at 2029. So that's a challenge they face because this is ultimately a factor that is leading to higher rates. You have to service these costs and when interest rates go higher, it just sort of compounds the government's sort of debt sustainability problem and the trajectory, given demographics, is not particularly favorable.
So that's a challenge that they face when they sort of set policies that this overlying debt sustainability problem that the policy makers don't have direct control over. Well, given these factors to your point, Jason, it will add a lot of intrigue to Friday's keynote address by Chairman Warsh. I'm sure we'll provide some takeaways from that on next Monday's episode.
I do want to get a bit more pointed on the title of your blog. Again, that's Policy Endgame. What exactly do you mean by it?
Well, kind of the policy endgame, ultimately, is some form of what I'd say fiscal dominance or financial repression and that becomes sort of inevitable. Now this is a scenario in which monetary policy, you know, interest rate policy, the Fed's balance sheet, is constrained by and sort of becomes subservient to fiscal policy because the federal debt servicing costs are just unbearably expensive if interest rates are just too high. And then the Treasury Secretary's sort of this buyback announcement is in some sense an attempt to lower rates.
But given that its toolkit is somewhat limited in what they can do, they really can't do much significantly without sort of the cooperation with the Federal Reserve. It suggests that some sort of action is at least on the table longer term and whether it is an explicit form of quantitative easing where the Fed just goes out and outright buys long term Treasury bonds and can, you know, engage in a policy of yield curve control in which they would say we will not allow the 10-year Treasury yield to get above a certain percent, let's say 3%, or the 30-year above 4%. So they'd buy what's necessary, you know, and any time investors want to sell they will step in and buy to keep interest rates contained.
Or there could be some other sort of combination of these or other measures. Now these are not far-fetched scenarios. Many investors kind of expected that this is perhaps the only solution to the U.S. debt situation.
We've seen it in other countries. You know, the Bank of Japan had a yield curve control policy measure in place essentially capping their 10-year Treasury yields at less than 50 basis points for a long period of time. They shifted away from that a couple of years ago.
So there's certainly some precedent in that. And ultimately it kind of comes back to the question of if a country has a large and growing sovereign debt kind of issue, how do you address it? And there's essentially three ways in which that can be addressed.
One is you actually just default on the debt. The U.S. government is not going to actually literally default on the debt, certainly not anytime soon or probably on our professional lifetimes, Dan. The second is you inflate your way out.
You just have a high inflation and, you know, sort of those debt obligations in the past are nominal, just become smaller and smaller because nominal, you know, inflation goes up or you try and grow your way out of it. You just have higher growth. You get more tax revenue.
You know, spending sort of, you know, doesn't rise as fast and therefore the debts and deficits become smaller and smaller as a percentage of the overall economy. The last one is of course what every politician would like but generating growth is not easy. I think that the more easy thing to do and the more likely thing is you have – you essentially run an economy hot, meaning you have high nominal GDP.
So it's some sort of combination of growth and inflation both go up. So I think that's the near term policy approach and it doesn't really require any form of explicit financial repression. You just sort of essentially tolerate inflation that's a little bit hot.
I think the Fed, by accepting inflation above 2% for over five years right now and based on their summary of economic projections, they don't think it's going to get to 2% for a couple of years. You have essentially a Fed that's essentially tacitly supporting a running hot kind of economy. This is a point we've discussed on this podcast going back even like one, two, three years ago.
And so there's – again, the policy measures all suggest that this is a possibility. Ultimately, this is still dealing with what I would say dealing with the symptoms of high interest rates rather than the underlying economic problem which is an unsustainable debt trajectory. But I think for the Feds and for investors, ultimately this is sort of a path that they have to consider.
It isn't necessarily a bad one for the economy or the financial markets. Two years ago, we did one of our reports on the Roaring Twenties scenario, assessing some of the key drivers, looked at how policy could play a central role, certainly uncertain and kind of a bit of a wild card. But one of the scenarios and sort of distinct possibility is that because of these fiscal situations, because of the debt situations, you'd have some – maybe just even a mild form of financial repression and they'll let the economy kind of run hot.
I think that's kind of what we're seeing two years later. So if the end result is at least a couple more years of a Roaring Twenties macroeconomic environment, again, for financial markets, it's not necessarily a bad thing. So Jason, if you take into account what you've covered with us today, potential policy actions, the rise in yields, what does this ultimately mean for investors?
What should investors be doing right now? Well, it is thinking about sort of a short and long-term aspect. So let's think about the rise in yields.
I mentioned a couple of the factors, what's going on, higher inflation expectations and higher inflation, Fed communication challenges. In the near term, literally over the next month to six weeks, we could get inflation data that is again relatively benign, confidence that inflation and disinflation is progressing. At the end of September, on the 30th of September, the Bureau of Labor Statistics will release updated inflation data where they're going to change the methodology of how they calculate certain parts of inflation, which it's kind of raised some questions of how they're accounting for things like software and AI-related investment.
So it could justify sort of changes in some of the methodology that could bring down on a year-over-year basis core PC inflation anywhere from 20 to 40 basis points. So you go from being above 3% to below 3%. So you're moving in the right direction.
The Fed and Kevin Warsh can also kind of clarify their policy framework at Jackson Hole, but also the September FOMC meeting. All that would help kind of yields to come down. That's our kind of basic case expectation.
We don't think the Fed is going to hike rates this year despite what the market's pricing. As the market gets a little more comfortable, yields come down. That is a positive for risk assets across the board.
It's one of the reasons why for the next six to 12 months, we're relatively constructive on kind of risk assets. A week ago when we talked about kind of this environment, you call it the Holland days of the summer. You mentioned that there is echoes of the summer of 2023 where interest rates, the tenure got to 5%, ultimately did decline a full percent over the course of the last two months of the year.
I think we could see something directionally, not in magnitude, something somewhere. So that's the near term. That's positive for equities.
On a longer term basis, even if we go down gently towards this policy endgame scenario as I mentioned, that is still for the time being and like for the next medium term outlook, the next one, two years plus, supportive of a growing 20 is a good economic regime. It's good for equities because ultimately, if you want to have higher nominal growth, you have higher revenue growth, the company's higher earnings. But it's also good for something like gold which has rallied 15% in August because ultimately, if you're willing to tolerate inflation, one of the consequences is a weak currency, sort of a dollar debasement concept.
In that case, what do you want to own as an alternative currency? Gold is one of the key beneficiaries. So on a medium or long term view, we think gold looks interesting.
We have a 5,200 price target for gold for next June. So it's rallied. But there's still a good upside over the next two, nine or ten months.
So a lot of issues going on with higher rates, the debt story is not positive. But I think for the markets, it's not necessarily a negative near term. At some point, there could be significant consequences.
But I think for our investment horizon, short to medium term, it's not a negative necessarily. It may actually be ironically kind of a positive. And we did see the equity team here at CIO raise their S&P 500 price target.
So that's important to keep in mind as well. That's correct. We now, for the S&P, have a price target of 8,400 by June of next year.
Given current levels, that's annualized us to more than a 10% total return by June of next year. Well, Jason, very thought-provoking here on this Tuesday morning. Again, do want to point you, our listeners, our clients of UBS, to Jason Splonk, which we have been talking about on today's episode, that title, Policy Endgame.
All eyes will be on Jackson Hole, Jason, this coming Friday. So look forward to reflecting on it with you during our conversation next Monday. Indeed.
Have a great week. You too. Thank you for tuning in.
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