DM Rates Outlook: Yield Curve Inversion to Ebb

• In the U.S. we see  inflation in the remainder of this decade being closer to 2.5% than 2.0% and also see higher real yields than the 0.45% that existed between 2015-19 (we see 2020’s supply problems, QT and inflation uncertainty meaning higher real yields). This means that nominal 10yr yields are unlikely to fall below 3% in the coming years and will likely remain above 3.5% in 2023-24.  

• The EZ yield curve will show a similar phase of less inversion in H2 2023 and then eventually a return to a positive slope in 2024.  2yr Bund yields are projected to remain elevated before a moderate  decline in 2024 as 75bps of ECB rate cuts are delivered (Figure 4), as the ECB is currently overtightening on policy rates, TLTRO roll off and APP QT.  10yr Bund yields are projected to remain elevated on H2 2024 recovery expectations and ongoing APP QT from the ECB.  We do not see a fall below 2.0% for 10yr Bund yields in 2023-24. 

• Finally, we forecast that the BOJ will increase the 10yr JGB cap to 0.75%, but will then not make any further policy changes.  This will see 10yr JGB yields rising to 0.70% by end 2023, but still helped by ultra-easy policy.   

Risks to our views: Greater than expected effects from Fed and/or ECB tightening on the economy causes a modest recession and then downside surprises on core inflation. Fed and/or ECB brings forward rate cuts to late 2023 and yields decline.  Yield curve would still become less inverted and swing to a positive yield curve by 2024.   

Figure 1: U.S. Treasuries Fed, Funds, 2yr and 10yr Yield Forecasts (%)

Source: Continuum Economics

Peak Fed Rates and Then Easing 

The June FOMC meeting (here) leaves open the prospect of one last 25bps hike from the Fed and most likely two 25bps hikes, as it seeks to reinforce a path back down to 2% inflation.  Tactically, whether the Fed delivers no further hikes or 25bps or 50bps in the coming months will dominate discussion over the summer and into the autumn, but the market should also focus on the Fed communications that the rate will remain elevated.  With uncertainty remaining over the path of core PCE and wage inflation, the Fed will want to avoid premature easing expectations from building.   Additionally, an easing in financial market conditions now would partially undo the purpose of current high policy rates.  

2yr yields are already discounting that a move lower in policy rates will be evident in 2024 and 2025 and the discount to the Fed Funds target can exceed 1% as it did in 2000 and 2007.  If expectations grow that policy rates have reached a peak, this may not initially encourage 2yr lower from current levels – given that the Fed will be cautioning against early rate cut hopes.  Thus we see 2yr yields remaining elevated and see only a modest drift up to 4.80% by end 2023.  2024 will likely be a different story for 2yr yields, as we forecast 75bps of cumulative Fed cuts at a pace of 25bps per quarter starting Q2.  This can see 2yr yields moving down structurally to 3.70% by end 2024 (Figure 1).  The discount of 2yr to the Fed policy rate will likely not go beyond 125bps, as the market will question if the Fed can really go below a 3% Fed Funds rate in 2025/26 and whether a core PCE inflation trajectory around 2.5% means that a small positive real policy rate is required.  

Figure 2: 10yr-2yr U.S. Treasury Yield Curve (%)  

Source: Continuum Economics

Our clearest strategic forecast remains for the U.S. Treasury yield curve to become less inverted and then to eventually swing positive in 2024 as recovery is seen in H2 2024.  The bottom of a slowdown or recession is normally the time that this structural trend starts, with the short end looking towards a rate cutting cycle and the long-end yields being dragged up by economic recovery hopes and asset allocation switches.  Could 2024 see this pattern broken and the yield curve remaining significantly inverted?   If the U.S. saw a moderate recession or if the economy had a soft landing (Figure 3), we would still see less yield curve inversion in 2023 and in 2024.   The economy is proving resilient and we see stagnation and at worst a modest recession, but the key question is whether core inflation settles at 3%, 2.5% or 2% -- notwithstanding that headline and core inflation trends are lower than  the 2022 peak. This means 10yr yields will likely lag 2yr yields once economic recovery comes into focus.   

The era of ultra-low nominal and real 10yr yields has passed, due to supply shocks (e.g. COVID, strategic competition U.S./China, Ukraine war) that will likely mean higher inflation uncertainty in the 2020s than the decade after the GFC.  Additionally, we also have the switch from quantitative easing to quantitative tightening.  A mild recession would not be enough for the Fed to abandon QT or go beyond a moderate rate cutting cycle from current elevated policy rates.  The monthly grind of up to $95bln of Fed Treasury and MBS holdings reduction will be a factor that keeps long-end real yields positive.  We feel that current 10yr yields inversion to the Fed Funds rate and 2yr yields reflects portfolio hedges against a hard landing and as momentum swings towards a slow U.S. economic recovery, 10yr yields will likely rise modestly.  We see 10yr U.S. Treasury yields at 4.10% by end 2023.  3.90% is  forecast for end 2024, with Fed rate cuts stopping long end yields from pushing up and dragging yields down modestly – though less than 2yr yields.  

Figure 3: Main Scenario Assumptions for 10yr U.S. Treasuries 

Source: Continuum Economics. 10% probability also exists of Fed hiking to 6% Fed Funds rate or above, which would drag up the yield curve in 2023 and mean greater inversion, but would likely mean a sharper fall in yields in 2024 on more aggressive easing than the baseline. 

ECB Rate Peak and Eurozone Debt Yields 

The ECB tightening cycle is getting mature after the 25bps hike in official rates at the June 15 meeting (here) and the question is will the ECB hike by a further 25bps or more in the coming months; we forecast one final 25bps hike.  This is crucial to the near-term outlook at the front end with 2yr Bunds at a discount to the effective o/n rate and ECB deposit rate.  A fluid debate on where the peak is in for ECB rates can keep 2yr yields elevated in the coming months (Figure 4).  By the autumn it will be clear that rates have peaked.  This can mean that 2yr EZ yields stop rising.  This can help 2yr Bund yields to close 2023 at 3.1%.  

2024 should see a clearer downward trend in 2yr yields as 75bps of ECB easing is actually delivered and we forecast 2yr Bund yields at 2.35% by end 2024.  Uncertainty exists around the end 2024 forecast, due to questions about ECB policy making.  The hawks could  restrain  easing in the key deposit  rate all the way back to a 1.5-2.0% neutral policy rate and this could curtail the scale of easing that is actually delivered by the ECB in 2024, but also market expectations of the policy rate trajectory in 2025 (we look for an additional 50bps of policy rate easing in 2025).    

Figure 4: CE ECB Refi Rate, German 2yr and 10yr Yield Forecasts (%)

Source: Continuum Economics 

10yr Bund yields can become more comfortable that inflation will return towards target.  However, our forecast of a technical recession in the EZ is not bad enough to really trigger new large safe haven flows towards government bonds and H2 2024 economic recovery forecasts will likely then switch the focus to traditional outperformance at the short-end and less yield curve inversion.  The 10-2yr German government curve is more inverted than 2000/2007 or 2008 (Figure 5), as the long-end has attract some flows this year after the debacle in bond markets in 2022.   The prospect are for inversion to be less acute in H2 2023, with 10yr Bund yields likely to drift up to 2.6% by end 2023.   

2024 should then eventually see a return to a positive 10-2yr Bund curve (Figure 4).  The rate cuts from the ECB should help 10yr yields to fall to 2.45%, but a return to sub 2% 10yr yields is unlikely. We would also argue that ECB QT keep up long-dated yields, especially with TLTRO’s roll offs having been aggressive in 2023 and mopping up excess liquidity.  Global supply issues and climate change investment will also mean small positive real 10yr yields. Finally, the rollercoaster for inflation will also likely mean that 10yr real yields will likely remain in small modest positive territory and this will also be an influence.    

Figure 5: 10yr-2yr Germany Treasury Yield Curve (%) 

Source: Datastream/Continuum Economics

In terms of 10yr BTP-Bunds, we see yield spreads close to current levels for the remainder of 2023.  The fiscal policy stance is conservative and credible and a downgrade to junk by Moody’s would be unwarranted and a surprise (here).  In 2024, we would see some modest widening of the 10yr spread to around 185bps.  A return to rising 10yr yields in DM government bond markets will be one factor.  Additionally, the ECB appears committed to sustaining APP QT and potentially expanding it in 2025 to starting PEPP QT.  This will mean a lot of paper for other investors to absorb in future years.  With Italian government bonds a domestically driven market, this will likely require an extra risk premia due to supply,  

JGBs and Gilts 

The outlook for 10yr JGB’s is a question of whether the BOJ will change the 10yr yield cap or not.  The 18 month policy review allows the BOJ flexibility, but we would see this as being in terms of timing and we still forecast a change in the cap from 0.50% to 0.75%.  We expect a move at the September/ October or December BOJ meetings, both to steepen the yield curve (to offset adverse QE effects) and also to produce some small policy normalization.  More importantly, this should be enough to allow the BOJ to keep the QE with yield curve control (YCC) policy in place, rather than abandoning QE with YCC altogether – which could cause a severe interest rate shock to the Japanese economy.  Actual QE purchases will thus likely be lower on a long-term basis, which helps keep QE with YCC as a safety net in case of major economic shocks.  10yr yields will thus likely push higher with this policy activity, though the downtrend in headline and core inflation (here) should mean that 10yr yields are not locked to the new 0.75% 10yr yield cap.  We forecast 0.70% end 2023 and 0.65% for end 2024 for 10yr JGB yields.  

10yr gilt yields have risen to a premium versus Treasuries as well as Bunds, amid market fears that the long-term trend in UK inflation is higher than the U.S. or EZ due to greater supply shocks (here).  Headline inflation should come down, but we project that core inflation will likely remain sticky for the remainder of 2023 before coming down clearly in 2024.  With the BOE having hiked in June the message is two fold; that a tightening bias remains, but that the market is discounting too much on rate hikes.  Long leading indicators of inflation suggest that core inflation will come down clearly and this could soothe the fears at the short-end.  However, 10yr yield spread versus Treasuries and Bunds will likely remain close to current highs through the remainder of 2023, until this becomes clearer in the core inflation trend.  We forecast 4.35% 10yr Gilt yields by end 2023.  In 2024, BOE rate cuts with core inflation coming down, plus lower DM 10yr yields should see 10yr Gilt yields to 4.1% by end 2023.   A potential Labor victory in the general election to be held before January 25 2025 could see lower 10yr gilt yields, if it means a closer relationship with EZ and less long-term inflation pressures. 

Figure 6: UK 10yr Spread Versus Treasuries and Bunds (%)

Source: Datastream/Continuum Economics