No, we continue to believe investors should hold US Treasuries in line with policy allocations. While the recent decision by Fitch Ratings to downgrade the sovereign credit rating of the United States added upward pressure on Treasury yields, we do not expect it will have a lasting impact. Looking forward, growing fiscal deficits and increased issuance are headwinds, but the economy and the Federal Reserve will remain the main drivers of yields.
Earlier this month, Fitch downgraded US debt from AAA to AA+, citing fiscal deterioration, the growing government debt burden, and repeated debt limit stand-offs. While the downgrade may have some symbolic significance, it likely will not have a lasting impact on the Treasury market. For one, the United States is the largest and most dynamic economy in the world, with some of the best investor protection laws globally, and we expect it will continue to pay its debt on time. Further, as was the case when S&P similarly downgraded the United States to AA+ in 2011, it is unlikely the most recent downgrade will result in any meaningful forced selling of Treasury securities or a significant change in investor behavior. Most investment mandates and regulators refer to Treasury securities specifically and not their AAA-rating, and we expect Treasuries will continue to benefit from a flight to safety during risk-off events.
Nonetheless, Fitch’s decision to downgrade US debt has focused attention on the worsening US fiscal picture and added to concerns about the challenging supply/demand imbalance in the Treasury market. According to the Congressional Budget Office’s latest forecasts, the budget deficit is set to increase to 5.9% of GDP in fiscal year 2023—up from 5.5% of GDP in fiscal year 2022 and well above the fiscal year 2015–19 average of 3.5% of GDP—and remain around 6% for the foreseeable future. Growing deficits and other factors, like the Fed’s quantitative tightening, imply a significant increase in the supply of Treasury securities for the public sector to absorb. According to several investment banks, this will potentially cause net issuance of Treasury securities to the public to increase from around $1 trillion in calendar year 2023 to close to $2 trillion in calendar year 2024.
This has added to upward pressure on interest rates further out the yield curve. Ten-year US Treasury yields increased by about 50 basis points in the previous four weeks and briefly touched 4.25% earlier today (August 15), slightly above its peak set last October, which was the highest since 2008. But this isn’t the only factor driving yields higher. Ten-year yields have risen from a recent low of 3.3% on April 6, as the Fed has continued raising rates and the odds of a recession have faded on the back of resilient US economic growth. Looking ahead, we expect softer inflation and the end of Fed tightening to limit any further rise in yields, but resilient growth and supply/demand imbalances will likely remain headwinds. Thus, the most likely outcome is for yields to remain range-bound in the near term. However, risks are tilted toward lower yields. The US Citigroup Economic Surprise Index is near its highest levels on record outside of COVID-19. Any weakness in the coming months could cause yields to fall. And despite the recent improvement in some real-time indicators, leading indicators still signal a recession. The Conference Board Leading Economic Index® declined for a 15th consecutive month in June and is down 8% year-over-year.
Additionally, Treasury valuations have cheapened as yields have risen. Ten-year Treasuries yielding 4.25% are more than half a standard deviation above their implied fair value based on long-term trends in economic fundamentals. Our analysis suggests overweighting longer-duration Treasuries is a winning bet over a three- to five-year horizon based on current valuations. That said, we maintain a high bar for extending duration, given the deeply inverted yield curve means investors are getting paid to take less duration risk in the near term and the growing risk of structurally higher interest rates in the long term. We would likely need to see either the odds of a recession increase, or ten-year Treasury yields move above 4.5%—or about 1 standard deviation above their implied fair value—before we felt like we were being adequately compensated for these risks. Ultimately, we continue to believe investors should hold Treasuries in line with policy targets.
TJ Scavone, Investment Director, Capital Markets Research