US Rates: Higher for longer

0:00Patrick Coffey:Welcome back to the Barclays Brief podcast. I'm Patrick Coffey and I'm in New York today where the US rates market has become one of the most important battlegrounds in the global economy. So as the US 10-year Treasury yield approaches 5%, I figured that our listeners would enjoy hearing from Dan Orlando, head of US rates trading here at Barclays. Dan, thanks a lot for finding time to step away from the desk on another very busy day in the market for you. Yes, thanks for having me. Busy day, busy week, but glad to be here. So quick reminder, we're recording this on Thursday, the 10th of September.

0:38Patrick Coffey:So prices will have changed a bit by the time this is released. But I want to start with the big picture, Dan, which is that Treasury yields have risen dramatically. Mortgage rates are elevated. The AI boom needs a lot of capital. Yet the U.S. economy continues to surprise on the upside. So why are yields so high today? And what do you think explains the resilience in the economy? Yeah, sure. So I think the root of the move, I mean, tendernodes have moved about 100 basis points since earlier in the year. It has been the sort of inflation backdrop and the energy story, obviously, centered out of the Middle East.

1:15And we went from a period of pricing in almost three rate cuts earlier in the year to now, you know, two rate hikes. and globally yields have reacted. Bond markets across the globe, all over Europe, Japan, have all sort of sold off in tandem. So certainly not a U.S. story in isolation. And, you know, we have central banks globally hiking rates. ECB hiked rates today, BOJ likely to raise rates. And we have a very consequential Fed meeting. And the CPI number will certainly be very important. Sure.

1:51Patrick Coffey:But typically, yield at these levels would have been expected to inflict much more damage on economic growth. Do you think it's different this time? And if so, why? And a rate simply less effective or other forces offsetting the traditional drag from higher borrowing costs? Yeah, this has certainly been a bit different than what a typical rate cycle or higher rates, the pain that might inflict on the markets. I think the first thing you have to point to is sort of the multi-generational CapEx expenditures that have been going on. There's not a rate dependency on this. There is a race to build data centers, invest in infrastructure, and to come out of the AI race on top.

2:39And whether the Fed hikes 50 or 100 basis points, I don't see that slowing down. And that CapEx has been largely responsible for keeping the economy extremely resilient, employing folks in, say, the construction industry and across all industries and has really been a big boom for the economy.

3:03Patrick Coffey:Yeah, I mean, typically the Fed raises rates to slow the economy. This time it succeeded in freezing the housing market, but it didn't cause the construction job losses that we've seen before because of the AI CapEx expenditure and growth there. Do you think that the market is underestimating how long policy rates need to stay elevated? So basically a rate's going to be a lot higher for a lot longer than people expect. Well, you know, we'll have to see. I mean, this is in reaction to much higher energy prices, mainly crude. You look at what Brent's doing, making new highs today. So we'll see. You know, the outlook for the Middle East is cloudy at best, right?

3:45We thought there would be some resolution, and there obviously hasn't been, and it looks like it could, in fact, drag on for much longer. But, you know, to your point on sort of the housing market, you know, you can look at things like, sure, construction jobs, maybe they're transferring over from what they might typically, you know, slow down in a typical housing cycle to more of the, you know, data center build out. And at the same time, you know, the housing market is largely tied to mortgage rates. We are coming from the COVID levels where money was very cheap and there were a lot of mortgages taken out at very low levels.

4:20And it takes some time for rates to be high for that to sort of make its way through the system.

4:27Patrick Coffey:Okay, so obviously higher rates is a global phenomenon, as you say, Japan, UK, Europe, US. But just think about the US for a moment because it's a market that you've been trading all your career. the U.S. Treasury announced a tripling of its long-end buyback program just yesterday. So for investors that don't follow the Treasury market plumbing day in, day out like you do, why does that matter? And can buybacks meaningfully influence those long-end yields, in your view? Yeah, so, you know, remember, buybacks are not a new tool. We've seen them predating the financial crisis. But, you know, a lot of the QE period coming post-2008 and really materially coming to the rescue during the COVID period.

5:09So can they? Yes, of course they can. But it sort of depends on size and scope. So the market is enormous. Can this help for a short term potentially? But the root of the problem is really deficits and more treasuries to come. It's questionable whether this can have a meaningful and lasting impact given its sort of size.

5:34Patrick Coffey:Well, it definitely didn't help yesterday, right? Because they're now at$6 billion and yields went up. There were some out there talking about kind of$8 or$10 billion in terms of Treasury buybacks. What number do you think would have appeased the market yesterday for yields to have been flat or maybe to have fallen? Again, I think you need to look through sort of the short-term effects of this. We had a$22 billion bond auction today, and it came through the market. Demand is quite high, and the market is very liquid. I think on a particular day, the market may move in reaction to an announcement.

6:12But big picture, it's going to react to the fundamentals, which is really the deficit and how much Treasury really needs to issue. The deficits look to be increasing. They're likely to increase coupon issuance next year. So whether they do$6 billion or$8 billion in the scheme of things, the size of the debt outstanding, it's really not significant. So maybe$8 billion in the short term, the market would have reacted more positively. But I would also point to the announcement itself. And within two days, the market sort of resumed its sell-off. So the impact was not lasting.

6:48Patrick Coffey:So this is a tough market for investors. You've got dynamics across macro equity and credit that are all sometimes working against investors. And the narrative seemed to be whipsawing this year faster than any other year that I can remember. How are investors positioned for this market? You know, what are your smartest clients doing at the moment to position for the next, you know, couple of weeks, couple of months? Well, I think you can definitely say yields are becoming attractive. So there is a desire to, you know, extend duration somewhat, even if it's into the belly of the curve, and pick up yield.

7:27But there's also been a surge of corporate issuance, we will this year will be a record, we'll have north of 2 trillion in IG issuance. And you can also receive, you know, your duration via corporate vehicles. I think a lot of that has happened. You've seen, you know, some of the hyperscaler names come to market with massive deals, a lot of them more long dated than typically as a whole, the IG calendar really looks like. And you've had an opportunity to buy longer duration at pretty attractive levels. The problem is there's a lot of it and it's global. So there's lots of competing alternatives.

8:02If the equity market holds up, which it has been, perhaps it's less attractive. But I think if we get to a level of rates where equities become less stable, I think you can see the market stabilize and perhaps perform.

8:17Patrick Coffey:Again, you reference that this is a global phenomenon that we're seeing right now, and there's lots of pain in the front end in the UK and European rates. What do you see as the most crowded position in US rates at the moment? You know, I think for most of the year, it's been via curve steepeners and not just in the US globally. Again, we went from a period of pricing three cuts to two hikes. When Moore sort of took the job, it was believed that he would go along with the agenda and cut rates. And in fact, at Jackson Hole, we saw he was pushing back quite a bit and sort of walking back some of his July comments to gain credibility as an inflation fighter.

8:58And in fact, energy prices continue to move upward. We have a very consequential CPI number tomorrow. But, you know, that steepener narrative has become extremely challenged with monetary policy globally. ECB hiked today, BOJ is going to hike, and it's looking like the Fed is, but they might hike as well. I think we're priced 70 % for moving SEP.

9:22Patrick Coffey:Okay, well, Dan, I've got to let you get back to the desk. I know it's a very busy day for you. So thanks a lot for finding the time to come up here and talk. Excellent. Thank you for having me. So I think what's most interesting about this conversation with Dan is how rising rates have shown less capacity to hurt the US economy than in prior cycles. If we think about it, typically the transmission mechanism is fairly straightforward. So the Fed raises rates, mortgage rates rise, housing activity slows, construction activity would be impacted, which hits jobs and spending, local economies contract, consumer confidence falls and ultimately spending retracts.

10:03Patrick Coffey:But right now, construction job losses have been limited because of the AI capex cycle, which has created this parallel source of demand for the same materials and skills. If you put it all together, what it means is the bond bulls, who expect a much weaker economy due to high yields, will likely be disappointed in the short term. Clients can read much more about this in our recent research note, The Dog That Did Not Bark, for now. Thanks a lot for listening to The Barclays Brief. Do hit subscribe and we'll be back at the same time next week.