- The US is facing a prospect of higher-for-longer inflation due to many factors including persistent energy uncertainty.
- Rates and yields are expected to stay higher for longer in the US with shorter-end yields likely to remain anchored.
- We think it is premature to add significant duration to your fixed income portfolios today and prefer to at least wait for a curve dis-inversion.
Rates expectations have seen massive repricing moves over the past year. Investors’ hopes for rate cuts (previously expecting as much as 6 – 7 cuts in 2024) have been dashed, with markets now pricing in just 1 – 2 cuts this year (Chart 1). Consequently, our call for shorter-duration bonds made at the start of the year has remained relatively resilient (compared to longer-duration bonds) – we observe this through Bloomberg Global Aggregate indices of different maturities (Chart 2).
With longer-end bonds already seeing a large increase in yields (e.g. 10y UST yields have increased from 3.88% to 4.58% YTD), investors may be tempted to extend the duration of their fixed income portfolios. In this article, we continue to advise against adding excessive duration to your portfolios and reiterate our preference for shorter-duration over longer-duration bonds.
Related article: Why we continue recommending Short Duration Bonds in 2024
Chart 1: Markets are pricing in significantly fewer rate cuts today compared to the start of 2024
Chart 2: Shorter-maturity bonds have held up better than longer-maturity bonds
Facing the prospect of higher for (even) longer inflation
(Note: Inflation and growth rates are YoY unless otherwise stated)
Recent price data in the US has not been encouraging for the Fed, with both CPI and PCE inflation remaining persistently above the 2% target (Chart 3). In addition, CPI inflation has come in above consensus expectations for 4 consecutive months (Dec 2023 – Mar 2024). For instance, CPI inflation came in at 3.5% in March, up from 3.2% in February, and higher than expectations of 3.4%. The Fed’s latest statement on 1 May also indicated their belief that there was a ‘lack of further progress toward the Committee’s 2% inflation objective'.
We see a risk that shelter inflation could continue putting upward pressure on broader inflation figures, especially if housing demand remains broadly robust in the US. CPI inflation has thus far been led by shelter (+5.7%), including both primary residence rent (+5.7%) and owners’ equivalent rent (+5.9%) – this is exacerbated by shelter’s sizeable 36% weight in the CPI basket. We find it worrying that housing indicators have continued to look robust (Chart 4) despite much higher mortgage rates today; while the pace of price increases has slowed since 2022, it has shown initial signs of rebounding in recent months.
Apart from shelter, investors should not understate the upside risks to energy inflation. Energy inflation came in at +2.1% YoY and +3.1% MoM in Mar (Chart 5). Multiple factors like geopolitical tensions and the ongoing green transition further muddy the near to medium-term outlook for energy prices, and we do not rule out sharp MoM movements in energy inflation because of such events, like the +41.6% MoM increase observed in Jun 2022.
Finally, inflationary pressures appear to be somewhat broad-based beyond shelter and energy. This can be observed not only in a breakdown of CPI inflation (Table 1) but also in PCE inflation (Table 2) which is the Fed’s preferred inflation metric; we highlight particularly the effects of energy and services which continue to be prominent contributors to inflation. For reference, a 2% PCE inflation target implies just a +0.17% MoM growth compounded over 12 months; based on existing figures (+0.3% MoM), we think the Fed still has some way to go before declaring its battle against inflation won.
Chart 3: Recent declines in inflation have stalled before the 2% target
Chart 4: Housing indicators are showing signs of rebound
Chart 5: Energy inflation could be an upside risk in future
Table 1: Selected breakdown of CPI inflation
| CPI Inflation - Selected Categories | MoM Change (%) | YoY Change (%) |
| Headline CPI | +0.6% | +3.5% |
| Core CPI | +0.4% | +3.8% |
| Food | +0.1% | +2.2% |
| Energy | +3.1% | +2.1% |
| Commodities ex Food / Energy | +0.1% | -0.7% |
| Services - Shelter | +0.6% | +5.7% |
| Services - Medical Care | +0.6% | +2.1% |
| Services - Transportation | +2.1% | +10.7% |
| Source: BLS, Bloomberg, iFAST compilations. CPI data are non-seasonally-adjusted as of March 2024. | ||
Table 2: Selected breakdown of PCE inflation
| PCE Inflation - Selected Categories | MoM Change (%) | YoY Change (%) |
| Headline PCE | +0.3% | +2.7% |
| Core PCE | +0.3% | +2.8% |
| Energy goods and services | +1.2% | +2.6% |
| Goods - Durable | +0.1% | -1.9% |
| Goods - Non-durable | +0.2% | +1.3% |
| Services | +0.4% | +4.0% |
| Services - Housing / Utilities | +0.5% | +5.5% |
| Services - Healthcare | +0.1% | +2.9% |
| Services - Transportation | +1.6% | +3.1% |
| Source: BEA, Bloomberg, iFAST compilations. PCE data are seasonally-adjusted as of March 2024. | ||
Expect rates to stay higher for (even) longer too
Apart from persistently elevated inflation, US economic activity remains robust, while the labour market also continues to look fairly tight. On the economic front, the US consumer remains robust (for now) as detailed in our recent article. While advance 1Q GDP estimates did come in weaker-than-expected at 1.6% QoQ (annualised), these were mainly due to inventory effects and greater import demand, with private consumption continuing to see solid growth at 2.5% QoQ (annualised) and private domestic final purchases coming in at 3.1%. Similarly, unemployment remains very manageable at just 3.8% while wage growth remains robust based on latest Employment Cost Index figures (1.2% in 1Q24).
In other words, our base case is predicated on our views on inflation (higher for even longer), economic growth (remain robust), and the labour market (stay fairly tight) in the US. Therefore, we retain our view that the Fed will hold rates steady in 2024, and that consequently short-end yields should remain anchored across the rest of 2024 too. Furthermore, we think longer-end rates and yields also have room to increase, especially if the US manages to achieve a recovery in demand, and/or if energy uncertainties persist over the medium to longer term.
What this means for duration
The inverted yield curve makes the risk-reward proposition for longer-maturity and longer-duration bonds less attractive. Theoretically, investors should get compensated more with higher yields for longer-end bonds given the higher maturity and duration risks; today, the inverted curve means they are generally compensated less. For instance, the term spread between 10y and 2y USTs currently stands at -0.3%, well below the historical average of 1.1% (Chart 6). Assuming short-end yields remain anchored, we think there is room for longer-end yields to increase resulting in a dis-inversion of the yield curve - for instance, assuming the 2y UST yield of 4.87% (as of 2 May) remains anchored, a good point to add duration could be when the 10y UST yield approaches 6%.
In addition, a higher-for-longer rates environment where nominal yields continue to see upward pressures would also favour shorter-duration over longer-duration products. We illustrate this through a theoretical sensitivity analysis using the current benchmark 2y, 5y, and 10y USTs (Table 3). There are two key takeaways:
- The prices of shorter-tenor USTs are less affected by yield movements compared to longer-tenor USTs, due to their shorter durations (which are in turn because of their lower maturities and higher coupons).
- USTs with higher coupons provide greater ‘guaranteed’ income which can support total returns. This generally favours shorter-tenor USTs which were recently issued at higher yields, compared to longer-tenor USTs which may have been previously issued at lower yields. Assuming yields drop by -100bps across the three tenors, a 2y UST would see a 6.5% lesser price increase compared to a 10y UST, and just a 5.1% lesser total return. Conversely, if yields rise by +100bps, a 2y UST would see a 5.8% lower price decline and a 7.1% higher total return.
Chart 6: Term spread is below its historical average as yield curve remains inverted
Table 3: Sensitivity Analysis of 2y, 5y, and 10y USTs
| Sensitivity Analysis | 2y UST [A] | 5y UST | 10y UST [B] | Difference [B - A] |
| Ticker | T 4.875% 30Apr2026 Govt | T 4.625% 30Apr2029 Govt | T 4% 15Feb2034 Govt | - |
| Maturity (years) | 2.0 | 5.0 | 9.8 | - |
| Modified Duration (years) | 1.9 | 4.4 | 7.9 | - |
| Coupon (%) | 4.875% | 4.625% | 4.000% | - |
| Yield to Maturity (%) | 4.87% | 4.57% | 4.58% | - |
| Price | 100.0 | 100.2 | 95.4 | - |
| Price change if yields drop -100bps (%) | +1.9% | +4.5% | +8.3% | +6.5% |
| 1y total return if yields drop -100bps (%)* | +6.8% | +9.1% | +12.5% | +5.8% |
| Price change if yields rise +100bps (%) | -1.8% | -4.3% | -7.6% | -5.8% |
| 1y total return if yields rise +100bps (%)* | +3.0% | +0.3% | -3.4% | -6.4% |
| Source: Bloomberg, iFAST compilations, iFAST estimates. Data as of 2 May 2024. *Total return includes effect of price change and two semi-annual coupons. | ||||
Recommendations
With a potential higher-for-longer rates backdrop in mind, we continue to prefer shorter over longer-duration bonds due to the former’s lower sensitivity to rates fluctuations. We also think investors should at least wait for a curve dis-inversion before considering adding duration.
Our primary fund recommendations with shorter-duration exposures to fixed income include the Nikko AM Shenton Short Term Bond Fund and the United SGD Fund. Both funds aim to preserve capital while outperforming a cash-based benchmark, each by investing in a portfolio of investment-grade bonds. Their current duration exposures are also fairly limited at 1.35y (31 Mar) and 1.10y (effective duration – 29 Feb) respectively. Investors can also consider our current money market recommendation – Fullerton SGD Cash Fund – which offers an even-shorter duration exposure (weighted average maturity of 43d as of 26 Apr) for a very low risk – its maximum drawdown since inception in 2009 is -0.02%.
Related article: Fullerton SGD Cash Fund – The king’s throne for your cash
Investors can also consider a cash-like portfolio. Options include our very own iFAST Auto-Sweep facilities, as well as the possibility of DIY-ing your very own cash-management portfolios – we provide a simple guide in the link below.
Related article: Cash Management: Two ways to capitalise on high cash rates
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