This analysis is by Bloomberg Intelligence Rates Strategist Ira F Jersey. It appeared first on the Bloomberg Terminal.
Treasuries could be poised to continue rallying if the market prices for a late-2023 recession, which is the base case for Bloomberg Economics. This suggests Treasury index returns next year should be positive. One question is what becomes of the relationship of Treasuries to stocks. We note a 2% move lower in the 10-year yield over the cycle is possible.
2023 recession means treasury rally starts now
Bloomberg Economics sees the US economy in a recession in late-2023, which suggests the Treasury market, particularly the long end, has scope to start a shallow rally. Even if the Fed maintains the federal funds rate at the peak during the early months of an economic slowdown, the long end of the Treasury market could rally meaningfully. Over the past 35 years, the 10-year Treasury began recessions about 1% above the trend from 1986, rallying eventually to 1% below trend, usually troughing after the slump. Although the mutli-decade downtrend has broken, a 2% drop in 10-year yields wouldn’t surprise us over the course the next cycle, with the 10-year Treasury to near 2%.
The strong upward economic impulse may lead to a shallower but relatively long slowdown. If so, the Treasury rally may also be relatively slow.
Treasuries’ worst year followed by mediocre?
This year will be the worst for Treasury total returns on record. (The structure was much different prior to the 1920s, so we wouldn’t rely on any return measures prior to that for historical reference.) Regardless, longer average maturity and very high duration amid ultra-low yields conspired to drag returns down, even as yields rose less than in the late-1970s. We think by year end-2023, however, the market will post a positive return. If we’re correct and the long end rallies as the economy fades, the return would echo those of ~5% that have followed the last two negative years.
There is a risk that continued inflation and a hawkish Fed could spur a modest selloff that leads Treasuries to return less than the yield. Regardless, we expect next year to be a large improvement over 2022 losses.
Is the correlation between treasury, stock returns shifting?
For most of this year, the return relationship between equities and Treasuries was negatively correlated, but over the past few months, the correlation has turned positive (on a 3-month horizon). It’s possible that stocks will continue to benefit if we’re correct and Treasury yields fall. But this would be due to improving valuation metrics. A slowdown in economic activity could affect revenue and profitability of some firms, so it’s possible that any positive correlation could turn quickly, depending on how fast the economy turns.
Bloomberg Economics expects a recession to begin in 2H23, which we think will benefit longer-term Treasuries. With the Fed reluctant to cut until inflation is very low, this suggests further yield-curve inversion, which may cause more pain for financial stocks.
Supply may stabilize in 2023
Although seemingly high, net Treasury issuance should slow in 2023 unless job losses dramatically affect tax receipts, causing deficits to increase. We expect the Treasury Department to maintain the current level of coupon issuance for at least 1H23. T-bill issuance is likely to be affected by management of the debt ceiling.
Another debt-ceiling fight is likely with a split Congress. We project the debt limit will be hit in February or March 2023, with cash and extraordinary running out sometime in the early autumn.
Bloomberg
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