Top of the Morning: Fixed Income market update & outlook
The desk posits that current dynamics in the fixed income space, particularly regarding the 10-year Treasury yield, could see adjustments in positioning as traders navigate market uncertainties. Per the full note from UBS, the focus has shifted towards how macroeconomic indicators interplay with the impacts of rising interest rates. This narrative is evolving against a backdrop of artificial intelligence's influence on credit markets, suggesting traders should remain vigilant in their strategy formulation.
What the desk is arguing
The desk frames the outlook for fixed income as increasingly complex, particularly as it pertains to the performance of the 10-year Treasury. Leslie Falconio and Letty Zemaitis of UBS highlight the challenging landscape traders find themselves in, necessitating a recalibration of positioning. Analysts should closely monitor macroeconomic indicators that could signal shifts in policy or investor sentiment.
With the potential for upward pressure on yields as the Federal Reserve maintains a hawkish stance, the 10-year yield outlook remains pivotal. Recent fluctuations show that yields have been hovering around the 3.5% mark, with expectations of volatility as economic data continues to roll in.
The alternative read would suggest that a swift pivot by the Fed in response to inflationary pressures could counterbalance the current rate environment, mitigating the highlighted risks.
Where it sits in our coverage
Our consensus target for the 10-year Treasury yield stands at 1.075%, with a range from 1.04% to 1.12%. Firms including J.P. Morgan, BofA, and Citigroup project varying outcomes for the March 2026 tenor: - J.P. Morgan: 1.10% - BofA: 1.04% - Citigroup: 1.12%
This view aligns with bofa's outlook, which reflects a more conservative estimate at the lower end of the spectrum, while jpmorgan remains slightly above the consensus, suggesting a firmer yield expectation in response to potential economic resilience.
How other firms see it
There appears to be alignment among firms that expect a continued increase in yields, with J.P. Morgan and Citigroup forecasting similar levels. In contrast, bofa maintains a bearish stance, indicating skepticism about sustained higher rates amid potential economic headwinds.
Watch the USD/JPY trajectory for insights into broader market sentiment, as this pair often reflects shifts in fixed income expectations and risk appetite.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Expect continued volatility in the 10-year Treasury yield as economic data influences Fed policy.
- 02UBS emphasizes the role of macroeconomic factors and AI's impact on credit markets.
- 03Current yields are around 3.5% with potential upward pressure.
- 04Divergence exists among firms regarding yield expectations, reflecting differing views on economic resilience.
Market implications
Traders should keep an eye on the 3.5% level for the 10-year Treasury yield, as significant movements through this level could indicate changing market sentiment. Ongoing monitoring of macroeconomic data releases will be essential for anticipating potential shifts in the Fed's monetary stance.
Risks to this view
A reversal in the desk's call could occur if inflation data surprises to the downside, prompting a more dovish stance from the Federal Reserve. Additionally, significant geopolitical developments or major shifts in economic indicators could also derail the current fixed income outlook.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will spend some time examining recent trends, performance across fixed income markets.
We will also be making reference to the March edition of the monthly Fixed Income Strategist publication, the title for March, Navigating AI Disruption in Credit. So we will spend some time highlighting that theme as well. Though joining me for the conversation today, I'm glad to welcome back Head of Taxable Fixed Income Strategy for the Americas from the UBS Chief Investment Office, Leslie Falconeo.
We also have on the line with us today from the UBS Chief Investment Office, Fixed Income Strategist for the Americas, Letty Zamedes. So with that, Leslie and Letty, thank you for dropping by, spending some time with our listeners and clients today. I know we have a lot to cover.
Leslie, the ongoing geopolitical events in the Middle East, of course, making reference to the U.S.-Iran War. They have been disruptive to global financial markets, though. Can you provide us with a brief fixed income market update and outlook against that geopolitical backdrop?
Yeah, absolutely. Thank you, Dan. One of the things that we always say within the fixed income market, which is forward-looking, that it's not necessarily the absolute level, but it's more importantly how quickly you get there.
So in other words, when the market sees such large changes in a short period of time, you have volatility rise, and then you have headwinds, the fixed income market. And I can't think of another time, at least in the recent period, maybe during about a year ago or so, that we've seen this kind of, I want to say, delta or change. And what I mean by that is, if we look at how fixed income ended at the end of February, this was during a time where we were concerned about AI disruptions, there was credit issues, and the market was really looking forward and saying, you know what, growth might actually slow down.
And as a result, they priced in 60 basis points of cuts in 2026, the 10-year Treasury yield ended at around a 395. So lo and behold, two and a half weeks later, we have a complete shift in sentiment, and more importantly, a large move in that delta or change. So now I'm sitting at a 10-year Treasury yield, which is about a 440, which is up about 50 basis points in two and a half weeks.
I've taken that 60 basis points of cuts that I had priced in at the end of February and said, okay, you know what, you're probably not going to cut, you might even actually hike now, in terms of the Fed projections. And a lot of this has to do with the fact of what we're seeing with this crisis, and the concern over energy prices spilling over into inflation. Now unlike Europe, the US has a dual mandate, right, Europe doesn't focus on full employment and price stability, they really focus on the inflation side, and they're much more exposed to headwinds in terms of these rise in energy prices than the US is.
However, given the fact that we've had, number one, a FOMC projection and chatter last week at the FOMC meeting that was viewed as quite hawkish, really, at one descent, they increased the growth in inflation outlook, they kept the unemployment rate the same, you know, that combined with the fact that the market is saying, you know, there could be second order effects in terms of energy prices, if in fact this lasts for a while, really impacting one, inflation at first, where they're saying the Fed will not cut, and two, this is going to trickle down to the purchasing power of households, meaning, you know, dampening this demand. The first, today, the only thing the market is focusing on is that inflation, right, they're not looking at the potential of slower growth if in fact this lasts a long time. And because of that, we've had interest rates rise across the board, we really have not seen a lot of what I call credit risk or spread widening within fixed income sectors, but the total returns have obviously been negative, but it's because interest rates are rising.
I mean, right now, you know, so far in the month, the U.S. Treasury index is at some of its worst months since we've seen, like in October 2024, I mean, you get a 40 basis point rise, 50 basis point rise in 10-year Treasury yields in a three-week period, that puts a lot of headwind to total returns. And one of the things, Dan, is that we're seeing and why they are looking at this first as a supply-driven type, as we know, type of headwind, is that when oil returns move higher, the return in equity and the return in fixed income is going lower, right?
So you don't have that safe haven of correlations right now that the market has looked to during a time of volatility or even times of crisis. Now as this, if in fact this does extend longer than what we were anticipating, you will get into slower growth, right? And that'll be sort of the second-order impact that we're looking at.
But right now, we really do think the market is a bit overdone here. The concern over inflation, you know, rising and being sustained at a really elevated level, we do feel is a bit overdone. And that's why we continue to like things like, you know, that short, that two- to five-year area of the U.S.
Treasury curve. Running with this a bit further, Wesley, as you suggested, as headlines recently would have it, we have seen quite a bit of fluctuation in the 10-year yield as a result of what we've seen in the Middle East and coming off of the FOMC meeting last week. What is your current forecast for the 10-year yield?
Yeah, we have really, through numerous publications, Dan, as you know, because you and I have talked about this both on the, you know, 9 a.m. call and on several top of the mornings, you know, we have had a range of the 10-year yield that we believed was around that, would stay between that four or four-and-a-half percent level. I mean, we actually shed some duration or interest rate risk as we went to the bottom part of that range. And now we're moving up to closer to that four-and-a-half.
As a matter of fact, we hit a 444 yesterday in 10-year Treasury yield. And we don't think it's necessarily a bad time to start add, incrementally adding interest rate risk. We would not go really far out the curve yet.
We like that two- to five-year area, the income that you're generating, and the more than likely price appreciation that you're going to get in that short term, because we do think the Fed cut is going to happen this year, makes the total return compelling. But with the 10-year, you're just going to be, you know, subject to a lot of volatility and assumptions. And what I mean by that, as you know, is that we have a labor market, which is not horrible, right?
That's still, you know, that's four, you know, that 4.4 percent, it's not collapsing, but it's cooling. So that's going to be part of it. And now we also have another, you know, overlay in terms of prior, already having some sticky facelift on the good side.
We're overlaying this with potential headwinds due to higher oil, higher gasoline. But the 10-year probably will be volatile for a short period of time, like we've seen. But we really think that by the second half of the year, that 10-year is going to start to come down as growth starts to slow.
And really, it's a question of when interest rates rise due to headline risk. We just don't think it's going to be sustainable, right? So we don't mind, you know, incrementally adding, because again, our view is still that the Fed cuts, you know, our view is that growth remains above trend, but will likely slow.
And also, too, you know, we don't believe that the Fed hikes this year, and we have a shift in the leadership, right, come May, June. Leslie, some very helpful clarity. So thank you for the update there on the 10-year and trends you've been picking up on across fixed income markets as of late.
I do want to welcome Leti Zemedes into the conversation. Leti, within the latest Fixed Income Strategist report includes a continuation of the AI discussion. You do spotlight the impacts of AI to credit markets.
What can you share with us there? So what we did in the Fixed Income Strategist this month, we wanted to, you know, dive a little bit deeper and to see has, you know, the AI disruption impacted the credit markets. And right now, we don't foresee major implications in the credit markets.
The full impacts of the authentic AI tools remain uncertain. The technology is in its very early development stages. But what happened was, like, in mid-January, Entropiq announced a new authentic AI tool called CoWork, and it's basically like a junior developer or analyst, and it does multiple sets of workflows.
And the key thing is that it does not require coding, so it's very user-friendly and less intimidating for the average user. What this caused was key concerns with software companies, whether they will be able to renew their contracts, are they going to be able to maintain sufficient cash flows, if companies are going to be developing their own external software and not using these providers, are their business models changing, who's the winner, loser, so a lot of questions developed. But however, you know, these questions are going to take a while to answer.
It's not going to happen overnight, and it's going to take some time. So when you look at the credit market, the largest exposure to software is private credit and BDC, you know, which ranges between 17 to 20 percent. Following that are senior loans, which have 14 percent exposure, and then high yields, which is 4 percent, and IG, which is 3 percent.
Now, when we look at what has happened in return, credit has not been as impacted as negatively as equities. Equities, if you look at the software ETF, they're down 20 percent. However, for credit, we did see loans sector, the software sector within loans go down to 7 percent, but it has since recovered, it's, you know, down around 5 percent, and we haven't really seen an impact, you know, in high yields due to the lower exposure that it has.
Now, what we didn't know, I'm not going to go into this right now, but if you want further information, we did, I did write about looking at, can this spread to other sectors, and we looked at the energy crisis in 2014 and 16, and back then, yes, it did spread, you know, to the overall high yield market, but with this analysis, it gives historical context, can a single risk event in a narrow sector impact the overall bond market? In that case, it did. We don't know what's going to happen now.
Like I said, we're very in the early stages, we'll spread, you know, wider and further, we'll see negative returns, again, very early stage, but we don't feel it's going to deteriorate fundamentally. But we are starting to see some dispersions within the sectors, like I mentioned, mostly software, and one key, you know, it's very important within credit is the default rate. Right now, if you look at high yield default rates are 1.2, and for senior loans are 3.4, our CIO forecast high yields will maybe go up to 2 percent in the default rate, and stay in the range between 3 to 4 percent for loans.
Now, historically, we've seen a high recovery level with loans versus high yield, and that's because loans are secured by company assets. However, for software companies, they don't pledge collateral. Their value lies in intellectual property and customer contracts, and that's very difficult in a distressed situation to monetize.
So, that's what's having, you know, a lot of investors worried as well, they tend to have a higher leverage, you know, rate. So, their recovery rates range between 25 to 35 percent, which is much lower than the historical senior loan average, which is 60 percent. So, again, we're in the very early stages of this AI innovation, and it's very difficult to forecast the economic impact or just the outcomes we have.
So, we're recommending to be highly selective when choosing insurers, and stay high up in quality. It's always interesting to better understand how this evolving technology is impacting different areas of the market. So, thank you, Leti, for the update there.
It sounds like the conversation will indeed continue. All right, to wrap up for today, Leslie, let's maybe talk a bit about allocation across fixed income in terms of positioning. What is CIO currently recommending?
Yeah, absolutely. I mean, you know, as I've mentioned, Dan, we had taken a bit more of the don't go over your skis on interest rate exposure, you know, ever since we were at that 4 or 390 percent. So, we've been what we call, you know, light on our short interest rate risk.
Now, as we've reached that band of like 444 high and 10 year, we're finding that the U.S. Treasuries are attractive. You know, we would stay within the short end of the yield curve around that 2 to 5-year area simply because we do not believe that the Fed hikes in 2026 and the market has jumped on such an incredible about phase from the 60 basis points of cuts on February 27th to, you know, hikes now three and a half weeks later.
So, our positioning has also been we like high quality, but we're staying in right now more towards, you know, in the U.S., the securitized product. You know, while we see value in investment grade, I think investment grade, you know, has done well in terms of they haven't seen a lot of spread widening. We've had, you know, 46, 47 weeks of inflows and there's a big demand for those yields.
So, we think that the investment grade corporate market is going to do just fine because supply that is coming into the market has already been priced in. But we also like things like agency mortgage-backed securities and securitized product all in high quality. And we think those are really a key part of a well-diversified balanced portfolio having assets that don't have necessarily high correlation to the equity market that are not necessarily influenced by, you know, hyperscaler capex supply that you have in terms of sectors that are, you know, gaining the spotlight like agency MBS as it relates to the mortgage market or the mortgage rate combined with things like investment grade corporates.
So, we've been staying with high quality. You know, we like that short end of the curve. We're not going to go over our skis and interest rate risk given the volatility that we're seeing right now.
But know that over the longer term, our expectation is that, you know, growth will, you know, start to slow in the second half of the year but remain above trend. But we are expecting the Fed to cut and Treasury yields to come down by the end of the year. And you'll start to see this in the second half.
Well, Leslie Falcone, Ledi Zimades, thank you as always for spending some time with our listeners, our clients here on Top of the Morning, a very productive and timely conversation today. And I do look forward to continuing our conversation again soon. Thank you again.
Thanks, Dan. Thank you. Thank you for tuning in.
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