Oil Prices Won't Drop, U.S. Treasury Yields Won't Peak

Citigroup has switched its allocation to a "late-cycle" mode, underweighting stocks and credit bonds while maintaining a neutral stance on U.S. Treasuries rather than going long.

Written by: Zhao Ying, Wall Street Insights

When will U.S. Treasury yields peak? This is one of the hardest questions for the current market to answer. Citigroup's latest quantitative cross-asset research shows that a decline in oil prices is almost a necessary precondition for U.S. Treasury yields to peak, while the ongoing geopolitical tensions keep oil prices high, suggesting that the ultimate peak in yields may not have arrived yet.

According to the Wind Trading Desk, Citigroup's report indicates that the front-end breakeven inflation rate's decline alongside falling oil prices is the most reliable leading signal historically for predicting the peak of the 10-year U.S. Treasury yield. However, the current breakeven inflation rate is still strengthening rather than declining, and the U.S. Dollar Index (DXY) has recently resumed its upward trend, both indicating that the peak in yields has yet to form. Meanwhile, signals from the market, such as widening high-yield bond spreads and the relative weakness of cyclical stocks compared to defensive stocks, exhibit characteristics consistent with a peak in yields, creating significant contradictions in current signals and making directional assessments extremely challenging.

In terms of asset allocation, Citigroup's cycle model currently follows a "late-cycle" strategy—underweighting stocks and credit bonds while overweighting bonds (excluding U.S. Treasuries) and commodities. The global macro strategy team maintains a neutral stance on duration, preferring to capture the interest rate differential between the European Central Bank and the Federal Reserve, prioritizing stocks over credit bonds.

Oil Prices Are a Necessary Condition for Yield Peaks

Analysts Alex Saunders and Vinh Vo from Citigroup's quantitative global macro strategy team reiterated their cross-asset analysis framework in the report, adding three segments of interest rate sell-off intervals exceeding 70 basis points, while the core conclusion remains largely unchanged.

Historical data shows that before the 10-year U.S. Treasury yield peaks, cross-asset performance exhibits a clear leading-lagging pattern. The front-end breakeven inflation rate typically declines 1 to 2 months before the peak in yields, while a peak in oil prices is almost a necessary precondition for the peak in yields. In contrast, the 2-year real interest rate often continues to rise after the peak in yields, serving as a lagging indicator.

Currently, the strengthening trend of the breakeven inflation rate has emerged, but the critical "decline" signal has yet to form. Citigroup points out that ongoing geopolitical uncertainties keep oil prices high, making it difficult to determine when oil prices will peak. In this context, any predictions regarding the peak in yields can only be further postponed.

Which Signals Are Effective and Which Are Not

Citigroup's research systematically reviews commonly used market judgment indicators, clearly distinguishing which indicators are leading and which can mislead judgments.

Regarding effective signals, the flattening of the 5-year to 30-year Treasury yield curve (5s30s) typically appears about a month before the peak, but this trend has reversed in the past 25 trading days, leading to confusion in signals. The widening of high-yield bond spreads and the relative outperformance of low-default-risk stocks also align with historical patterns of yield peaks. Additionally, high-quality stocks usually perform strongly within a 200-day window before and after the yield peak, which has been reflected recently; however, growth stocks often peak before the yield peak and continue to underperform thereafter.

As for ineffective or lagging signals, Citigroup clearly states that core CPI and overall CPI year-on-year data are lagging indicators, and the recent hot CPI readings do not rule out the possibility that yields have already peaked. The 2-year real interest rate will also not reverse at the yield inflection point. The VIX index has almost no reference value for timing yields, but historically tends to decline after the peak is confirmed.

Current Signals Are Contradictory

Citigroup admits that comparing current market dynamics with historical patterns reveals significant conflicts in the signals, making it difficult to make clear directional judgments.

On one hand, the performance of cyclical stocks relative to defensive stocks has weakened for 2 to 3 consecutive months, and high-yield bond spreads are widening, all of which align with market characteristics after yield peaks. On the other hand, the breakeven inflation rate continues to strengthen, the U.S. Dollar Index has recently resumed its upward trend, and oil prices remain supported by geopolitical factors, all pointing to the possibility that the ultimate peak in yields is still ahead.

Citigroup believes that if there are positive developments in the geopolitical situation—especially after the midterm elections—it will significantly increase the probability of oil prices peaking, thereby creating conditions for a sustained decline in U.S. Treasury yields. Until then, the recent trend in yields will remain highly uncertain.

Under this judgment framework, Citigroup's cycle model has switched to a "late-cycle" mode. Specifically, this model underweights stocks and credit bonds, while overweighting bonds (excluding U.S. Treasuries) and commodities, and has recently further reduced stocks to an underweight position. The global macro strategy team maintains a neutral stance on duration, leaning towards the interest rate differential between the European Central Bank and the Federal Reserve, and prioritizing stock exposure over credit bonds. The core logic of this allocation is that in the absence of clear signals for a peak in yields, and with oil prices and breakeven inflation rates not showing decisive declines, a neutral rather than aggressively long position on U.S. Treasuries is more prudent.

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