UBS sees Fed hike fears as excessive with 10-year yield above 5.1%

A 10-year yield above 5.1% (5.2%+ as I update) raises the discount rate on equities and makes it harder to justify high valuations, especially for rate-sensitive growth stocks. Higher yields also support the US dollar, which tends to weigh on the Australian dollar. The RBA's widely expected hike on Tuesday gives AUD some offset by keeping policy rates higher relative to the US. If UBS is right that October hike odds are overdone, that could reverse quickly: a softer core PCE revision could trigger a sharp rally at the front end of the Treasury curve. The weak five-year auction is worth watching: another poorly received sale would suggest debt supply, not just the Fed outlook, is pushing yields up.

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Bond markets are pricing an October Fed hike, and UBS believes those expectations are premature. The bank forecasts one rate move in December, with easing inflation and robust earnings supporting equities through a measured tightening cycle.

• The 10-year Treasury yield climbed above 5.2% for the first time since 2007, rising roughly 15 basis points on Wednesday and continuing higher on Thursday
• The flash composite PMI topped 58 in September, marking the strongest private-sector expansion since mid-2021, while input costs increased at their fastest rate in almost four years
• A $70 billion five-year note sale cleared at the highest auction yield since 2006
• Futures imply around a 70% probability of an October Fed hike, up from just under 50% a week ago
• UBS expects one hike in December, then a pause, with inflation declining over the next six months
• UBS rates fixed income as attractive and projects S&P 500 earnings growth of 25% this year and 14% in 2027

The sell-off in US Treasuries has pushed the 10-year yield above 5.1% for the first time since 2007. UBS argues the investment backdrop remains constructive nonetheless, stating that markets are pricing in more Federal Reserve tightening than is likely to occur. Yields rose roughly 15 basis points on Wednesday and extended their gains on Thursday, while the S&P 500 slipped just under 1% in Wednesday's trading.

Three factors drove the move. Oil prices have climbed on renewed Middle East supply concerns, economic data has come in strong, and demand was lackluster at a $70 billion five-year note sale, which cleared at its highest yield since 2006. The S&P Global flash composite PMI rose above 58 in September, marking its fourth consecutive month of acceleration and the strongest private-sector expansion since July 2021. Input costs grew at the fastest pace in nearly four years as fuel and transport expenses increased.

Traders have responded by leaning into a near-term hike. Fed funds futures now place the probability of an October increase at around 70%, compared with just under 50% a week ago, when the Fed lifted its policy range to 3.75% to 4%.

UBS views that pricing as too aggressive. Its base case is one more hike, in December, followed by a pause. It notes that the median projection from policymakers points to steady rates through 2027, despite a hawkish tone from some officials. The bank expects inflation to decrease steadily over the next six months. It cites two reasons: an expected downward revision of around 0.2 percentage points to core PCE inflation in the Bureau of Economic Analysis's annual revisions later this month, and favorable base effects in the first half of next year.

On bonds, UBS acknowledges that concerns over government debt have helped lift yields this year, but argues that high debt does not automatically imply poor returns. It rates fixed income as attractive, seeing higher starting yields as a source of solid portfolio income. Income-focused investors may prefer shorter maturities to limit duration risk. The bank also sees tactical value in medium to long-dated high-quality bonds, and in medium-tenor credit from stronger investment-grade issuers.

The bank is also positive on earnings. It views the latest PMI as confirmation that the US economy is on solid ground, with AI investment adding a further tailwind. UBS projects S&P 500 earnings growth of 25% this year and 14% in 2027, and earnings growth for the MSCI All Country World index of 26% and 14% over the same period. It expects that growth to lift global equities over the next six to 12 months.

UBS continues to recommend positioning for further equity gains. It also suggests capital preservation strategies, broad commodities and alternatives to make portfolios more resilient. Whether that view holds will depend heavily on how the Fed responds to the next round of inflation and activity data.