Top of the Morning: Fixed Income Strategist - Optics and opportunities
The desk sees the recent rise in fixed income yields, discussed by Leslie Falconio from UBS, as an indicator of robust economic growth, with expectations for stability through Q4. Per the full note, the notable increase in the 10-year and 30-year yields—most significantly from 4.37% in June to a peak of 4.63% in August—suggests that investors are navigating renewed risk appetites alongside persistent inflation. As traders evaluate the implications of these movements, they should consider how this fixed income outlook aligns with any potential shifts in FX dynamics influenced by interest rate expectations.
What the desk is arguing
The desk positions that the recent surges in nominal yields are reflective of solid economic fundamentals, with real yield growth dominating the narrative. Per the full note, Falconio highlights that as real yields climbed, so too did implications for risk assets, indicating a stable fixed income landscape moving into year-end.
This perspective is backed by an observed performance shift, where 10- and 30-year yields reached levels not seen since 2002. The desk notes that yields increased rapidly, suggesting a market recalibrating for growth prospects and inflationary pressures, despite potential shocks.
Where it sits in our coverage
The desk's view aligns with a Dec-26 target of 1.10 from jpmorgan, while bofa presents a contrary stance, targeting 1.04.
The bullish sentiment on economic growth and yields aligns our desk at the upper end of the target spectrum, indicating a prevailing view that remains cautiously optimistic amid the backdrop of economic indicators.
How other firms see it
Aligning with the desk's perspective, firms like jpmorgan echo a bullish outlook on yields and growth, while bofa counters this with a more cautious view given inflationary concerns.
Traders should monitor the USD/EUR pair closely, as its trajectory is likely to be influenced by US Treasury yield movements and relative monetary policy stances from the Fed and ECB.
What the calendar says
No high-impact events are scheduled in the forthcoming month that could address these fixed income dynamics directly.
01The rise in fixed income yields is driven by solid economic growth and inflation concerns.
02Ten-year and 30-year yields have reached their highest levels since 2002, indicating market adjustments.
03Consensus targets for currency pairs reflect the bullish sentiment in fixed income markets.
04With no direct high-impact calendar events, traders are advised to watch upcoming economic indicators closely.
Market implications
Monitor the USD/EUR pair for any reactions to the evolving yield landscape, particularly at resistance levels around 1.07, which could signal trader sentiment as fixed income yields stabilize.
Risks to this view
A surge in inflation data or unexpected central bank policy shifts could disrupt current yield trajectories, leading to potential reversals in the fixed income outlook and complicating FX strategy.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. Today we will turn focus back to fixed income as we will highlight the latest fixed income strategist report from the UBS Chief Investment Office, the title Optics and Opportunities.
And joining me for the conversation today, fortunate to have with us the publications lead author, head of taxable fixed income strategy for the Americas from the UBS Chief Investment Office within UBS FSI, Leslie Falconeo. Leslie, welcome back to Top of the Morning. Thank you for dropping by on this Thursday.
Thank you, Dan. Leslie, just diving into the fixed income strategist, it does spend some time reflecting on the quarter that was. So let's talk about Q3.
It was an eventful period for fixed income investors, the month of September in particular. So what are your reflections on the quarter's performance and how do you see the fixed income landscape evolving through year end? Yeah, I mean, we wrote a very comprehensive lead in the fixed income strategist month this month with optics and opportunities.
And when we think about the third quarter and the third quarter move, it was actually quite remarkable. I mean, around the end of June, you were a 437 in 10-year yields, or at some point at the end of August, you were at a 463, and then all of a sudden we had both 10- and 30-year yields jump to the highest that we've seen since 2002. Now as we all know, and this has been written about quite a bit, I mean, most of the increase in the nominal yields is driven by real yields, which does first and foremost indicate that growth is on solid footing.
And we agree with that outlook and what we've seen in the second quarter growth and our expectations for third quarter is that growth remains on solid footing. But the amount that the yields increased in such a short period of time, and that's one of the things that we always highlight, it's not necessarily about the level but the pace that you get there, it was very, very fast. So our outlook with that was that the market is pricing in, in our opinion, a more hawkish Fed path than we are.
I mean, it oscillates back and forth, but right now they're looking for, say, another three hikes through 2027. We were looking for another two and a potential, high potential, that they begin to cut in the latter part of 2027. But really the main reason was when we had this move in interest rates, it wasn't just about the fact that, okay, yes, we had continued uncertainty regarding what's happening in the Middle East.
But particularly at the end of the month, we saw this decoupling and oil was actually coming down and yields were continuously rising. And that was probably what was happening globally. It was due to uncertainty.
It was due to the fact that it's not just about whether these supply-driven inflation concerns are going to fade, which we do believe they will, but it came more about reaching that 2% target in inflation expectations, or an inflation target. So that was really the main driver. And because break-even inflation expectations did not necessarily skyrocket, and they didn't throughout the quarter, and particularly throughout the month, it's really looking at how long does it take to get to that target.
And that uncertainty has allowed for, or I should say investors demanded, a bit more compensation when it comes to investing in long-end. Now what we see today, and one of the plays that we had made was that we added to our interest rate risk in this backup, there's no question. We added a little bit too early.
We probably added around that 5% level, moving from short-end treasuries, which we still hold, but adding risk assets in that 5% to 7% or intermediate part of the curve as yields rose. For a moment, for a couple of weeks, we obviously were hanging our head a little bit just how quickly rates moved to that 5%, 3%, 5%, and 10% or treasury yield levels. But now we're actually back down a bit, and more importantly, we're down even though some of the inflation numbers are not necessarily abating, but the market's already pricing this in.
So when we think about how we go to year-end, our expectation is that more than likely, once you're going to have volatility, there's no question, we saw a volatility spike. We think that's going to continue to happen, not just because of some of what's happening in the Middle East or the uncertainty regarding Fed action, the midterm election, all these kinds of variables might keep volatility high. We still think it's a good idea and prudent to start sort of average costing and adding on to that interest rate risk.
We don't necessarily chase rallies, but what we do is we want to add to interest rate risk as these rates rise. And what we're seeing today is, because of some of the corrections that we're seeing within the equity market, we have had strong CPI and PPI numbers, but yields contentionally go down in the treasury market for two reasons. One, they moved up way too fast in a much shorter period of time, and normally when that happens, it's not a sustainable move.
You know, and two, again, the market's already pricing in a fairly hawkish outlook. So, you know, we like to stay in the short end of the part of the curve with the treasury side. We're in the intermediate and risk assets, which we continue to like, mainly in high quality.
But we do have dabbing in what we call these carry type trades, whether it's preferreds or high yield. But we're mainly in the high quality sector in that five to seven year area, and we do look for yields to trend lower into year end. And during 2027, as we see growth start to slow a little bit, but again, it is not a straight line.
So, you know, investors need to be cognizant of, you can see volatility, you don't have to chase markets, you wait for the right opportunity in terms of when those yields start to rise, which they will again. We've come down quite a bit in the past couple of days, but we're not in the all clear yet. So, and that's really how we're playing it.
A lot of factors at play impacting fixed income return. You mentioned inflation as well, Leslie. We had a disappointing print there this week, and we'll dive a bit deeper into positioning in a few moments.
I do want to single out the widening in credit spreads. Investors have taken notice of that in recent time. What does the widening in credit spread signal to you, Leslie?
You know, right now it's really simply more of a normalization. I mean, you're widening from incredibly tight levels. And we have written every time throughout the past, most of this year, how tight the spread range has been for both things like, you know, either whether it's investment grade corporates or high yield, both the higher and the lowest spectrum credits.
You know, really we're in a very, very tight spread. So, we're seeing some widening out now, I think, as volatility has risen, you know, as real yields have gone up. While that does signal a growth, strong growth, it also can impact what we call financial conditions, which have been tightening as rates rise.
I mean, borrowing costs are higher, obviously, but we don't look at these widening spreads as some sort of catalyst going forward. If anything, we view it in more of an opportunistic fashion because, again, these balance sheets, both household and corporate balance sheets, are in healthy positions. The yield that you're earning, and I know we'll talk about, you know, our allocation in a bit, but again, what we highlighted in the fixed income strategies was just how much that compounding income is a tailwind to the total returns.
And so, having the spread widening, if this isn't something that we think is a red flag, if we think it's a normalization, it could continue for a little bit as volatility is heightened. But overall, we think the fundamentals are intact. But you are seeing and have seen throughout this year a dispersion, and we think that's going to continue.
So, you need to be selective in how you're allocating. And Leslie, as I was reading through the fixed income strategies, something that jumped out to me, Agency MBS posted its worst monthly performance in September since 2022. This is to how much did rates volatility factor in there to performance, and are there concerns about any underlying fundamentals?
Yeah. I mean, Dan, honestly, it was a big, big performance driver in terms of those headwinds when you talk about rate level and volatility. I mean, we like the Agency MBS sector.
We had an attractive on it in 2025. It was one of the top performing sectors, and it actually was doing very well, or at least as expected, in earning that carry, staying within a tight spread range, similar to the investor-grade corporate side. But when you have, again, it's not necessarily about the level but the pace of the rate move.
When you have a move that we saw in September, where within a week and a half, you're going up 30 basis points or so in 10-year treasury yields, sectors such as Agency MBS do have a bit of an issue keeping up, so spreads widen. Not only do they widen because of the volatility, but obviously, the mortgage rate is now, at the time, it was around 7.5%. It's much higher than what it has been in the past year, but I also believe, too, that when we think about the holders of Agency MBS, more than 53% of outstanding mortgages are locked in, say, around that 4% level.
So when everyone talks about this, they always talk about what we call this negative convexity in Agency MBS market. It really comes to fruition more when you have these sharp moves, because overall, the convexity profile in mortgage-backed securities has improved tremendously since the COVID and since we saw that 60 basis points in 10-year treasury yields. But this kind of volatility that we saw, the sharp move rates, the sharp rise in whether it's a move index or swaps and volatility, definitely had headwinds on performance.
We've kept our attractive. We don't think that you're going to see that spike with that same magnitude going forward. That doesn't mean that yields aren't going to rise or have pockets of increasing yields, but again, it's not just about the level, it's about the pace.
We just don't think we're going to have that drive in terms of those dramatic moves. So we do like the Agency MBS market. We think it's a great diversifier.
We like the high quality. We like the liquidity. And what you're getting in yield for some of these current coupons is a great tailwind to total return, particularly given the credit quality versus AIG corporates.
Leslie, as we begin to close out, just to reinforce some guidance, as you've pointed out, with rates volatility still heightened, how should fixed income investors navigate this environment and what are your positioning recommendations at this time? You know, I think the biggest, I think the most important thing when we think about the levels that we locked in at and the cushion that it provides, I mean, I can't emphasize again, you know, and I think people really have a tendency to take this for granted. When we say yield levels, not since 2002, 2002 these are.
So it's not like other cheats from 2025, we're talking about multi-decade highs in yield. So I really don't discount the amount of cushion that you have from this compounding income that we feel will be a driver of returns. It's very important not to worry about the next 25 basis points or 30 basis points up or down because, unfortunately, we are in an environment with a lot of unknowns.
You know, if we look at yields rising globally, the fact that the market has, you know, a hawkish Fed, we don't know how long this Middle East crisis goes on for, we have mid-term elections, we have supply, I mean, all these kinds of variables are going to push, you know, performance back and forth. But overall, we do think that the economy stays on solid footing. We do have, you know, growth slowing in the months ahead, but, you know, at least a trend.
We do think the Fed will probably, you know, hike two more times, which is not a huge headwind to risk asset performance. It's simply 75 basis points of hikes as a return of some of the cuts they did in 2025. But how we are positioned with this is that, you know, we are keeping our portfolio diversified.
We have mostly high quality in there. We do have some what we consider, you know, lower credit quality, whether it's $25 preferreds that have had some of their worst yearly returns in decades, if not ever, and some of the high yield that we had added on when spreads started to widen out, we're going to keep those positionings on. But we mostly have a diversified in that five to seven years.
We have both high quality, we have a little bit of carry from those credit components, but we extended our interest rate risk out to the intermediate part of the curve. You know, we're still slightly cautious on the back end, that's just tactically, because of volatility structurally, we think yields are cheap. So if you're a buy and hold investor going into, you know, long immunities right now, given those tax equivalent yields is a great opportunity.
But again, we do think volatility is going to last, you know, for the next six months or so, just given all of this uncertainty that we have. But we do have a diversified portfolio. We extended interest rate risk.
We're not worried about every 25 basis point move in 10-year treasury yield, because it's going to happen. But over the next six months, we look for yields to go below 5%, anywhere between, say, 4.5% and 5% for 2027. You know, we do look for the Fed to hike in December, as the market is already pricing in.
And we think that risk assets, while spreads might go through pockets of vulnerability of widening, the income that you're earning will far gives you a cushion in terms of spread widening, because we don't think there's going to be a catalyst in the economy going forward. Well, Leslie, very helpful touch base this morning, as it has been a challenging environment for fixed income investors. So do appreciate your clarity and guidance on how to navigate this environment and how to position accordingly.
And of course, we do look forward to having you back again soon. Thank you, Dan. Thank you, Leslie.
Again, today, we have been joined by Leslie Falconeo, head of taxable fixed income strategy for the Americans from the UBS Chief Investment Office. And again, do want to highlight the October edition of the Fixed Income Strategist publication, which Leslie has been referencing on today's episode, Optics and Opportunities is the title. This report now available for you, our listeners, our clients up on UBS.com slash CIO for clients of UBS.
Please be sure to reach out to your UBS financial advisor to receive a copy of the latest Fixed Income Strategist report directly from UBS studios on Dan Cassidy. Thank you for joining us. This material has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is published for informational purposes only.
For information, please visit our website at UBS.com slash working with us. For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at UBS.com slash CIO dash disclaimer.