US 10-year yields near 5% on credit stress, not optimism

The prevailing mood in markets is poor today, yet there is some encouraging news underneath for equities and gold.

Treasury yields have dropped by 12 to 14 basis points along the entire curve, with growing conviction in the market that the Federal Reserve will neither raise rates next week nor take a particularly hawkish line. The 10-year yield is 13.5 basis points lower and has moved close to the significant 5% mark.

That represents a considerable slide from 5.34%, the post-financial-crisis peak touched earlier this month.

The bearish way to read the yield decline is that the AI trade is losing momentum and investors are hunting for havens. That concern applies specifically when looking at AI-related positions. Elsewhere, much of the economy has no direct link to AI and is not especially exposed to an AI investment pullback. If bond traders are detecting the prospect of softer inflation or a less profligate federal government, then sectors such as home builders would be among the beneficiaries.

Unsurprisingly, the XHB exchange-traded fund that tracks home builders is 3% higher on the day.

Consistent with that, the Russell 2000 surged earlier in the week, and even as the Nasdaq slides 2.4% in a rough session, the index is only 0.3% lower today.

Clearly, the potential triggers for a more substantial decline in rates include peace in Ukraine, Iran or Saudi Arabia. The most favourable outcome would be all three together.

From a technical standpoint, the decisive line now is the move under 5%. A continued rapid descent in yields, with no favourable inflation news to justify it, would be a real cause for concern.

BMO's view is as follows:

The health of corporate credit markets has been in focus as investors remain on guard for emerging signs of stress in the financial system and broader economy. Most immediately relevant, tech bonds have come under pressure, and the rise in credit default swaps on AI-related issuers has been weighing on risk sentiment. While the emerging signs of credit stress have yet to spill over into the broader economy or financial conditions, they have contributed to safe-haven demand for Treasuries, particularly in the long-end.

So the decline is the right response, yet it is happening for the wrong reasons.