Extra Credit

“Climbing the Staircase”

Today’s Interest Rate Environment is More Complex

Yields on US Treasury notes maturing five years and longer have topped 5% for only the second time since 2007. In 2023, extending duration proved wise—the longer, the better. We believe now is another good time to leg into duration, but the circumstances are more complex.

What’s Driving Yields

Fed Chair Warsh tied the rise in yields to economic strength, geopolitics and competition for capital. We agree. The US economy has exceeded expectations and conflict in Iran has put a premium on oil and the inflation outlook. Most important is the double-barreled capital demand from an artificial intelligence (AI) investment boom and troubling federal deficits. There’s a bid for capital, and yield is the clearing price. The data supports this narrative. Ten-year real yields have risen 95bps year-to-date while breakevens are barely up (+5bps). This suggests a repricing of growth on top of existing fiscal concerns, not a broken inflation anchor.

The Front End Has It Right

Forward rates have been signaling tightening monetary conditions for months. The FOMC got on board in September with a hike and a hawkish message. The forward market is pricing in 3-4 more hikes, which would bring SOFR to nearly 5% in 12 months. We think that’s about right. The Taylor Rule suggests SOFR of at least 4.75%; a 5% handle is plausible if the current backdrop persists.

This all means forward rates are pricing in the Fed’s likely tightening path for this cycle. That should give investors comfort to extend duration, at least through the intermediate part of the curve.

Long End is a Different Story

Thirty-year paper must absorb competing capital demands, a grim US fiscal outlook and rising yields across developed bond markets. Those are real concerns, even if long yields over 5% already reflect much of that risk. The upside here may not be worth the risk.

The Next Step Up

Structural drivers (demographics, security concerns, soaring investment, fiscal strain) have been lifting nominal and real yields. The term premium has normalized since the quantitative easing era, and real yields are already high versus history. This repricing has looked like a staircase—much like a mirror image of the secular disinflationary move down. Preserving principal as we climb would mean shortening maturity while yields push toward the next step, moving out the curve once that level is reached, then repeating. Positive reinvestment risk helps the process. We believe we’ve reached the next step up with a higher trading range and it’s time to extend.

Bond managers can now build a portfolio with 6-7% yield and average quality of investment grade that can absorb a further 100bps+ yield increase without a negative total return. Stock-bond correlation often increases in rising rate environments, but bonds can still offer diversification and ballast, especially in a surprise deflationary shock, an AI capex bust or other scenarios the market isn’t positioned for.

Important Disclosure

This marketing communication is provided for informational purposes only and should not be construed as investment advice. It is meant to offer a snapshot of select market developments and is not a complete summary of all market activities. Investment decisions should consider the individual circumstances of the particular investor. Any opinions or forecasts contained herein reflect subjective judgments and assumptions of the author and do not necessarily reflect the views of Loomis, Sayles & Company, L. P. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted. Data and analysis does not represent the actual or expected future performance of any investment strategy, account or individual positions. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources. Opinions are subject to change at any time without notice.

The Credit Health Index (CHIN) is a macro tool created by Loomis Sayles. The CHIN is currently managed by the Loomis Sayles Applied IQ team. It is a proprietary framework that utilizes a combination of macro, financial market and policy variables to project US corporate health.

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