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Upgrading U.S. Treasury holdings on Fed tightening expectations

Higher yields and potentially excessive Fed tightening expectations create room to unwind our U.S. Treasury underweight – a mainstay for most of the last six years. We upgrade Treasuries, favoring short-term bonds. In turn, we take profits: downgrading U.S. equities to neutral to manage potential volatility around the AI buildout and trimming our Japanese government bond (JGB) underweight. We retain our conviction in AI fundamentals and preference for AI within U.S. equities.

The 10-year Treasury yield has risen 110 basis points this year to around 5.25%, driven mainly by higher real interest rates rather than inflation expectations or term premium. Two forces are behind the rise in real rates: Intensifying competition for capital is pushing up the neutral rate, while Middle East tensions and higher oil prices have driven a sharp reversal in Fed rate expectations.

Since January, markets have priced in 160 additional basis points of Fed tightening over the next 12 months. We think that is overdone. With term premium averaging around 75 basis points since September, higher yields offer a more attractive entry point. At current yields, our analysis suggests a 75-basis-point cushion against further yield increases over 12 months before total returns turn negative. That supports adding U.S. Treasuries, especially at the short end, where we see the greatest scope for Fed tightening expectations to unwind.

Locking in attractive income

We are adding Treasuries from across the curve. For most of the last six years, we’ve been underweight Treasuries, turning neutral in spots. Now, yields have reset toward our long-held higher-rates view, and we want to lock in some attractive income.

Ten-year Treasury yields sat near 0.9% back in October 2020 when we first went underweight and have since surged to 24-year highs above 5.3%.

We are upgrading shorter-term Treasuries to overweight, where we see scope for excessive Fed tightening expectations to unwind, and long-term Treasuries to neutral as higher yields now provide better compensation for interest-rate risk.

We also trim our underweight in JGBs, held since July 2023 when 10-year yields were at 0.4%-0.5%, compared with above 3% now. We fund the Treasury upgrades partly from U.S. agency mortgage-backed securities that have been a stable source of income in portfolios and we are now neutral.

Adjusting U.S. equity overweight

We also fund the Treasury upgrades by closing our long-held U.S. equity overweight to neutral. This is a short-term risk management move, reflecting our belief that investors must be more dynamic in today’s volatile macro and market regime. We are also monitoring growing focus on AI policy and the AI buildout in jurisdictions across the country.

Our fundamental convictions on AI transformation remain intact. Higher rates are increasingly differentiating companies by their ability to generate earnings and returns above the cost of capital.

We still favor AI-related companies and listed infrastructure, where growing demand and scarcity in critical infrastructure support attractive returns. Existing infrastructure could grow even more valuable amid this scarcity. Despite narrative swings, we believe fundamentals will ultimately prevail. We also maintain our emerging market equity overweight. FactSet data shows third-quarter earnings for S&P 500 companies are expected to grow nearly 30% year-on-year.

Bottom line

We are managing near-term risk, not changing our core convictions. Higher yields offer an opportunity to add Treasuries, funded partly by taking profits on U.S. equities. We remain constructive on AI and stand ready to add risk again as visibility improves and attractive entry points emerge.

Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.

Wei Li, Managing Director and Global Chief Investment Strategist at BlackRock Investment Institute, and Rick Rieder, Chief Investment Officer of Global Fixed Income – BlackRock, contributed to this article.

Disclaimer

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