© 2024 M&T Bank and its affiliates and subsidiaries. All rights reserved.
Wilmington Trust is a registered service mark used in connection with various fiduciary and non-fiduciary services offered by certain subsidiaries of M&T Bank Corporation including, but not limited to, Manufacturers & Traders Trust Company (M&T Bank), Wilmington Trust Company (WTC) operating in Delaware only, Wilmington Trust, N.A. (WTNA), Wilmington Trust Investment Advisors, Inc. (WTIA), Wilmington Funds Management Corporation (WFMC), Wilmington Trust Asset Management, LLC (WTAM), and Wilmington Trust Investment Management, LLC (WTIM). Such services include trustee, custodial, agency, investment management, and other services. International corporate and institutional services are offered through M&T Bank Corporation’s international subsidiaries. Loans, credit cards, retail and business deposits, and other business and personal banking services and products are offered by M&T Bank. Member, FDIC. 
M&T Bank Corporation’s European subsidiaries (Wilmington Trust (UK) Limited, Wilmington Trust (London) Limited, Wilmington Trust SP Services (London) Limited, Wilmington Trust SP Services (Dublin) Limited, Wilmington Trust SP Services (Frankfurt) GmbH and Wilmington Trust SAS) provide international corporate and institutional services.
WTIA, WFMC, WTAM, and WTIM are investment advisors registered with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply any level of skill or training. Additional Information about WTIA, WFMC, WTAM, and WTIM is also available on the SEC's website at adviserinfo.sec.gov. 
Private Banking is the marketing name for an offering of M&T Bank deposit and loan products and services.
M&T Bank  Equal Housing Lender. Bank NMLS #381076. Member FDIC. 
Investment and Insurance Products   • Are NOT Deposits  • Are NOT FDIC Insured  • Are NOT Insured By Any Federal Government Agency  • Have NO Bank Guarantee  • May Go Down In Value  
Investing involves risks and you may incur a profit or a loss. Past performance cannot guarantee future results. This material is provided for informational purposes only and is not intended as an offer or solicitation for the sale of any security or service. It is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. There is no assurance that any investment, financial or estate planning strategy will be successful.

August was meant to be lazy and easy. Inflation slowed, the Federal Reserve (Fed) hiked again (which was widely expected), corporate earnings were solid enough to not be scary, and markets were taking the U.S. government’s refunding in stride. But investors rarely have the luxury of remaining comfortable for very long, and bond markets played the part of spoiler last month. A series of events drove the 10-year yield to its highest level in nearly 16 years, leading to the worst monthly performance of large-cap stocks this year, according to the S&P 500. The crucial questions are “Why?” and “Where does it go from here?” We’ve recently moved to a more constructive outlook for the U.S. economy but see continuing recession risk, which, along with high valuations, is mainly why we maintain our underweight to stocks. We also think long-term interest rates are more likely to move back down than up, bolstering our case for our current overweight to core fixed income.

A one-two-three punch for bond yields 

After spending most of the past year drifting in a range of 3.75%–4%, last month’s bond market selloff sent the 10-year yield to its highest level since October of 2007, which was almost a full year before the failure of Lehman Brothers and the onset of the GFC, or global financial crisis (Figure 1). There were three market developments that led directly to the shift in sentiment last month: an upside surprise in planned borrowing by the U.S. Treasury, Fitch’s downgrade of U.S. government debt, and a move by Japan’s central bank that pushed that country’s sovereign yields higher.

Figure 1:
Highest bond yields in 16 years
U.S. 10-year Treasury yield and components (%)

Chart showing that bond yields of U.S. 10-year Treasury and components are the highest they have been in 16 years.

That the U.S. government needed to borrow heavily was a surprise to no one. The Treasury had depleted its cash reserves by the time of the June 2023 debt ceiling agreement, and those reserves needed to be rebuilt. The increased borrowing had gone smoothly until July 31 when the government said it planned to borrow $1 trillion in 3Q, sharply higher than the $733 billion it had estimated just three months earlier, triggering selling pressure in longer-term Treasuries.

Fitch, the rating agency, compounded the selling pressure a few days later when it downgraded the U.S. government’s credit rating (as discussed in a recent Wilmington Wire blog post) to AA+ from AAA, citing “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA- and AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.” This was, in layman’s terms, what everyone already knows, that Congress hasn’t shown a willingness or ability to get its long-term borrowing under control. It’s practically the same thing S&P said in August 2011 when it made the same move, making Fitch’s decision appear laughably anticlimactic. Nevertheless, Fitch’s move contributed to the selloff.

The third development came from abroad. The Bank of Japan (BoJ) loosened its grip on that country’s interest rates by relaxing its yield curve control (YCC) policy that has been in place since 2016. In an effort to boost growth and inflation, the BoJ has been holding the 10-year yield at 0%, which has in turn driven Japanese fixed income investors more toward U.S. securities. The BoJ’s adjustment last month makes its local bonds more attractive on the margin, and drives investors from the U.S. back to Japan, pushing U.S. yields higher. While each of these three events is very real and not expected to reverse, we do think the market has likely overreacted, pushing yields a bit too high.

Figure 2:
U.S. economic data keep surprising to the upside helping drive rates higher
U.S. Citi Surprisie Index and 10-year yield; Atlanta Fed GDPNow tracker 

Chart showing how, using according to the Atlanta Fed GDPNow tracker, economic data has been driving rates higher

Breaking it down

Another way to look at Treasury yields is to break them down into two components. Thanks to the existence of Treasury inflation-protected securities (TIPS), it is straightforward to see how much of a Treasury yield is compensating investors for inflation, with the remaining return representing the real yield. And both components reflect a combination of investors’ expectations as well as uncertainty surrounding those projections.

Expectations for 10-year inflation peaked well over a year ago, in April 2022, ticking above 3% for the first time in the 25-year history of the data. That was when consumer prices were ramping up and the Fed was in the early stages of its campaign to rein in those pressures. Since that time, investors have been calmed by decelerating inflation, and expectations have declined to more normal levels, around 2.4% in August.

It has been the real yield driving the most recent surge in Treasury rates and which can be seen as a proxy for economic growth, as well as the uncertainty around future growth levels. The U.S. economy continues to defy gravity with strong consumer spending, a possible bottoming out of the housing sector, decent capital expenditure projections, and solid job growth. To wit, the Citi U.S. Economic Surprise Index has been on a steady positive march upward since May 2023, and the Atlanta Fed’s GDPNow tracker is currently calling for stronger than 5% growth in 3Q 2023 (Figure 2). This is all in spite of the swift increase in interest rates over the past year and a shock to the U.S. banking system in early 2023.

Figure 3:
Current positioning
High-net-worth portfolios with private markets*

Table showing current positioning for high-net-worth portfolios with private markets

While the strong economic data may seem to be unambiguously good news, there is a downside. The rise in real yields is reflecting strong economic growth but also the possibility of more rate hikes and a sustained plateau for rates from the Fed to accompany that significant expansion. One interpretation of the full breakdown shown in Figure 1 is that the U.S. economy has returned not to a pre-Covid-state, but a pre-GFC-state, when growth was higher, but so was inflation, as well as the entire yield curve. The pain endured by equities in August could be less a recession signal as much as it is a sad farewell to the low-rate environment that endured and relentlessly supported stocks for a decade before Covid.

We do think fixed income markets may have overreacted to this recent spate of strong economic data. Although we have recently upgraded our outlook—moving to a baseline expectation of a soft landing and the U.S. avoiding recession—we do not expect a no landing scenario, where the economy simply remains strong. The environment is too challenging for that. High rates are weighing on firms’ capex plans and also on consumer spending. Additionally, consumers have spent down the bulk of their dry powder, or cash reserves. Along with the soft landing, we’re still looking at a below-trend economy in the 1%–2% growth range. As that plays out in the data, we expect to see some relief with longer-term rates drifting back down. Indeed, a handful of data releases late in the month supported our view, pushed rates back down a bit, giving a boost to equities.

Holding portfolios steady

Given all the uncertainty, we are maintaining our current, mildly defensive position in portfolios. We hold a modest underweight to equities versus our long-term strategic asset allocation target, specifically within U.S. small cap and international developed equities. We think our full allocation to U.S. large cap remains appropriate and have been encouraged by its overall strong performance this year (Figure 3).

We hold an overweight to core fixed income. That asset class suffered losses in August due to the rate movements described above, but losses were worse in equities, so this relative positioning was advantageous. We expect rates to come down over our nine- to 12-month tactical horizon as economic growth expectations recede a bit, so this overweight should be additive. We also hold a small overweight to cash that we expect to deploy in future months.

Stay Informed


Sign up here to receive insights designed to help you succeed.

Sign Up Now

WTU Newsletter Card
WTU Newsletter Handler