How much higher can bond yields go?

Episode Summary

Executive Summary: The episode argues that stronger-than-expected growth and sticky inflation have pushed central banks, especially the Fed, closer to peak rates, but likely to hold them high for longer. Rick Reeder expects rates to plateau before easing in 2024 as growth slows, while Praveen Korapati sees the U.S. 10-year around 4% by year-end with upside risks if the Fed hikes more. The discussion also covers yield-curve inversion, Japan’s policy normalization, and why Europe may now be a relatively attractive fixed-income and equity market.

Main Topics: Fed terminal rate and the path of U.S. yields (Priority: 5/5): Both speakers think the Fed is near its peak hiking level, though sticky inflation and resilient labor data leave room for more tightening or a longer pause at elevated rates. Korapati’s base case is a terminal Fed funds rate of 5.25%-5.5% and a 10-year Treasury near 4% by year-end. Why bonds sold off after early-year optimism (Priority: 4/5): Reeder argues markets entered the year too pessimistic on growth and too aggressive in pricing Fed easing and recession risk. He says pent-up demand, excess liquidity, and a broad desire for yield helped drive the reversal in bond prices. Deep yield-curve inversion and cash attractiveness (Priority: 5/5): The transcript explains that short-term rates above long-term yields reflect both recession fears and the belief in a low long-run neutral rate. Reeder says front-end yields above 5% make cash unusually attractive, even though he expects the curve to steepen later. Japan and Bank of Japan normalization risk (Priority: 4/5): The speakers expect the BOJ to tweak rather than abruptly end easy policy, potentially shifting yield-curve control from the 10-year to the 5-year point. They see limited spillover from a modest change, but more disruption if Japanese inflation and wages force a broader normalization. Europe vs. U.S. relative value (Priority: 4/5): Korapati and Reeder both suggest European rates and assets look more compelling than U.S. equivalents, given pricing, valuations, and expectations for slower growth. They note Europe still carries geopolitical risk, but see more room for attractive returns there. Portfolio strategy in a higher-rate environment (Priority: 3/5): Reeder says investors can now manage risk with more tools than in 2022, including duration, currencies, and options, instead of simply hiding in cash. He sees quality income assets, especially front-end fixed income, as attractive.

Key Arguments: Markets overestimated recession risk and Fed easing at the start of the year, which set up the bond-market reversal. The Fed is likely nearing the top of its hiking cycle, but rates may stay restrictive for a prolonged period because monetary policy works with long and variable lags. Sticky inflation is most problematic because it affects necessities like rent, energy, and food, while wage gains are concentrated in lower-paying service sectors. A restrictive Fed does not necessarily need to sacrifice millions of jobs to get inflation from 3% to 2%; the tradeoff may be politically and economically unattractive. The U.S. 10-year Treasury is likely to settle near 4% in the baseline case, but could rise if the Fed extends hikes or remains higher for longer. The inverted yield curve is being driven not only by recession fears but also by expectations that the economy can ultimately bear a lower neutral rate than current policy. Cash is unusually attractive because the front end of the curve now yields more than 5%, making liquidity a legitimate return source rather than a zero-yield placeholder. In 2024, as growth slows and stimulus fades, rates should drift lower again, and the 10-year could potentially reach 2.5% in a favorable scenario. The BOJ is likely to modify yield curve control carefully, with limited immediate market spillover unless inflation and wages force a more aggressive exit from easy policy. Europe appears more interesting than the U.S. on a relative-value basis because yields, credit spreads, and equity valuations are more attractive. Investors can now hedge with duration, FX, and options rather than relying on cash alone, making 2023 a more investable year despite uncertainty.

Data Points: Fed terminal rate (baseline): 5.25%-5.5% - Goldman Sachs Research baseline forecast for the rate at which the Fed stops hiking. U.S. 10-year Treasury yield forecast (end of year): 4.2% - Korapati’s forecast for year-end U.S. 10-year yields. U.S. 10-year Treasury yield peak: 4.25% - Expected peak in the third quarter before easing slightly. U.S. 10-year Treasury yield forecast (next year): 4.0% - Expected to drift toward estimated long-run equilibrium. Potential U.S. 10-year downside scenario: 2.5% - Reeder said a drop to 2.5% next year is possible if growth slows materially. Commercial bank deposits: Almost $18 trillion - Used by Reeder to illustrate the amount of liquidity in the system. Money market funds: $5 trillion - Part of the liquidity/pent-up demand backdrop supporting demand for yield. Excess savings estimate: About $1.7 trillion - Reeder’s estimate of remaining household excess savings. Front-end cash yield: Above 5% - Reeder’s point that sitting in cash now offers meaningful income. Last year portfolio cash level: 20%-25% - Reeder’s description of how defensive portfolios were in the prior year. ECB terminal rate forecast: 3.75% - Korapati’s revised baseline forecast for ECB tightening. Potential ECB upside risk: 4.0%+ - He noted some members of the ECB could push rates higher if data remains strong. UK 10-year gilt forecast: 4.0% - Korapati’s view for long-run nominal UK rates. Japanese 10-year swaps: 82 bps - Used to argue markets already anticipate BOJ yield-curve-control tweaks. Fair value for 10-year JGBs: ~80 bps - Korapati’s estimate of Japanese government bond fair value. Potential spillover from BOJ tweak: 15-20 bps - Estimated short-term market impact if BOJ moves YCC from 10-year to 5-year.

Pivotal Quotes: "I think we're getting close to the top of the mountain, and I just think we're going to sit at the top for a long time." — Rick Reeder: His summary of the likely interest-rate path: near the peak, then high for an extended period. "The front end of the curve is getting you five... you can get above five for functionally sitting in cash." — Rick Reeder: His argument that cash and very short-duration instruments are unusually attractive now. "We think there are some upside risks here, particularly given sticky inflation and somewhat resilient growth, a strong labor market." — Praveen Korapati: Explaining why the Fed could end up above the baseline terminal rate.

Implications: For investors, higher-for-longer policy favors short-duration income, selective credit, and disciplined hedging. If growth cools in 2024, yields may fall, but near-term volatility remains elevated, especially around Fed, BOJ, and ECB policy shifts.