UBS: Fed hike bets overdone, three forces may calm Treasury market

UBS's stance runs counter to the more aggressive end of market expectations for the Fed. Should inflation data come in softer as the bank anticipates, the front end of the curve would likely benefit the most as traders unwind rate-hike wagers. Oil remains the key wildcard: with Brent hovering near $100 amid the Iran conflict, any meaningful progress toward reopening Hormuz traffic would alleviate a major upward pressure on yields, while renewed attacks on shipping would push them higher. The bank's wariness toward the longest maturities points to ongoing steepening pressure from fiscal deficits and AI-related issuance even if shorter yields fall. Friday's payrolls report and Fed officials like Logan, who supports another 50bps or more of tightening, serve as the next major hurdles.

--- UBS contends that the bond market has priced in an excessive number of Fed hikes and too little optimism, and argues that current yields compensate investors for enduring the turbulence.

Summary:

• UBS sees Treasury volatility remaining high in the near term but rates fixed income remains Attractive
• It views market pricing of nearly four additional Fed hikes by end-2027 as excessive, pointing to softer core PCE and benign revisions
• Enhanced energy flows through Hormuz and renewed diplomatic efforts could allay inflation concerns
• Policymakers might take additional measures to curb long-term yields, such as altering liquidity rules
• UBS estimates that 2-, 5- and 10-year yields would need to climb roughly 255, 110 and 65bps before losses outpace income
• The bank remains wary of the longest maturities due to deficits and AI-related issuance

UBS anticipates that volatility in US Treasuries will remain elevated over the short term but identifies three potential catalysts that could help steady the market, and it still rates fixed income as Attractive despite the steepest global bond losses in two years.

In a memo issued before Thursday's partial bond recovery, UBS said the selloff resulted from both cyclical and structural factors. Treasuries had declined for seven straight sessions through Wednesday, pushing the 10-year yield above 5.3% for the first time since 2007 and the 30-year to its highest in 24 years, while global government bonds suffered their worst quarterly loss since 2024. The bank cited the Middle East conflict, with Brent holding near $100 a barrel, robust US growth, heavy bond issuance by hyperscalers funding AI expansion, persistent fiscal deficits and hedge fund repositioning.

The first catalyst is further disinflation. Markets are pricing in close to four more quarter-point Fed hikes by the end of 2027, which UBS considers overly aggressive. It noted that August core PCE inflation came in below expectations, that annual revisions showed a more benign inflation picture, and that the three-month annualised core rate fell to about 2%, the lowest since July 2024. With the Fed starting this tightening cycle from a much higher base than in 2022, the bank sees a long series of hikes as improbable.

The second is improved energy flows. UBS acknowledged the war, now in its eighth month, has dragged on longer than anticipated, but said both Washington and Tehran have economic incentives to strike a deal, and that diplomatic efforts appear to have intensified since the UN General Assembly. Clearer signs of recovering traffic through the Strait of Hormuz could ease inflation worries and support Treasuries.

The third is policy action. The bank noted the US Treasury doubled its buyback operations in August, with only a transient effect, but said policymakers could consider additional steps, such as adjusting bank or insurance liquidity rules to create more demand for government debt, if rising yields threaten stability.

UBS argued that today's higher yields provide a buffer that was missing in 2022. By its estimates, two-, five- and 10-year Treasury yields would need to rise by around 255, 110 and 65 basis points respectively before capital losses outweigh income. The bank favours shorter maturities for income-focused investors and selective medium- to long-duration high-quality bonds for those able to withstand volatility, while staying cautious on the longest maturities given fiscal worries and AI-related issuance.

Since the memo was written, the 10-year yield briefly touched its highest since 2002 on Thursday before easing, though the energy risk remains present after another tanker was struck in the Strait of Hormuz the same day.