DM Rates Outlook: Peaking Policy Rates and Less Yield Curve Inversion

• EZ debt yields will likely also follow a similar process of less yield curve inversion, as the ECB becomes comfortable that inflation will be consistent with target by H2 2024 and allow the ECB to ease by 75bps. We see 2 and 10yr Bund yields at 2.45% and 2.35% by end 2024.Lack of visibility from the ECB on long-term neutral policy rates will likely create uncertainty about the scale of easing and slow the decline in 2yr yields.
• Finally, 10yr JGB yields can move up further into 2024, as the BOJ allows yields to rise towards the 1% yield cap over a number of quarters.Only a technical adjustment in the key policy rate from -0.1% to zero is likely however. We see 10yr yields at 0.95% by end 2024.

Risks to our views: A mild recession in the U.S. would lead to larger than projected Fed easing in 2024, which would bring yields down across the curve – though still with disinversion occurring. The spillover would impact government bond yields in other DM countries except Japan. 

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

Source: Continuum Economics

Peak Fed Rates and Then Easing 

The September FOMC meeting (here) left the option of one last hike on the table and it remains a close call for November. However, this would be a final fine tuning of policy rates and the key question for U.S. Treasuries into 2024 is when will the Fed starting cutting rates and by how much. This is crucial for the discount of 2yr to Fed Funds and also the shape of the 10-2yr yield curve.

Fed chair Powell has previously floated the concept that the Fed Funds will likely be reduced as inflation comes down to avoid effectively increasing the real Fed Funds rate, which puts the onus on the CPI and PCE trajectories as the prime driver of future Fed policy easing. Provided that the U.S. economy manages a soft landing then the economy and labor market should remain secondary. Though we see a slowing of 2024 growth on the lagged effects of monetary tightening, this will be unlikely significantly rush the Fed to ease policy or cut aggressively. We look for three 25bps cuts starting Q2 and expectations of a similar pace into 2025.

The 2yr discount to Fed Funds is currently not as wide as earlier in 2023 and more importantly was wider during the early stages of the 2000 and 2007 easing cycles (Figure 2). We would see 2yr yields at 4.95% by end 2023 reflecting a view that Fed Funds has peaked and then we see 2yr yields falling consistently through 2024 (Figure 1) and ending 2024 at 3.80% yields. This is not as aggressive a discount as either 2000 or 2007 when recession loomed, but the delivery of some Fed rate cuts in 2024 should provide comfort that the Fed will likely continue to ease into 2025 and this will be partially anticipated.

Figure 2: 2yr-Fed Funds Spread (LHS) and Fed Funds (RHS) (%) 

Source: Continuum Economics

In terms of 10yr yields, our theme of less yield curve inversion has already started to play out over the last 3 months, as the market switched to a soft landing view and reduced the probability of recession. Yield curve disinversion will likely stall now until the market becomes clear on the soft landing view through the autumn/winter.However, as Fed easing arrives in the spring, we would see a less inverted yield curve resuming, though mainly driven by 2yr yields declining. For end 2023, we see 10yr U.S. Treasury yields at 4.25%, as absolute yield levels are attractive enough if you believe that the Fed can get core PCE inflation down to 2.5%. An extra risk premia would only be required in a world where core inflation does not get below 3%.As 2024 progresses, we would expect a small decline in 10yr yields to 3.90% helped by ongoing Fed easing though at a smaller magnitude than 2yr yields and leading to a small positive 10-2yr yield curve by end 2024 (Figure 1).

In terms of scenarios for 10yr yields (Figure 3), the two alternatives would mean a different outlook for 10yr yields. However, the modest recession scenario would likely involve a larger movement in yields, as the Fed would likely cut more actively in 2024 than the baseline and this would filter through the curve. In contrast, a sticky inflation scenario could see a small further rate hike, but would be more about delaying 2024 rate cuts and this would likely cause less of a reaction in 10yr yields. 

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

Source: Continuum Economics 

ECB Rate Peak and Eurozone Debt Yields 

We feel that the ECB tightening cycle has reached a peak, which is evident in the rate pause at the September meeting and the softening of the hawkish message (here). The slow process of ECB communications does however mean that forward guidance on the prospect of rate cuts will likely not arrive until just before the 1^st cut arrives in the spring. Thus we look for 2 and 10yr yields to remain close to current levels for end 2023 (Figure 4).

It certainly requires ECB easing to arrive for 2yr Bund yields to fall consistently, as the discount of 2yr yields to the depo rate is wide and has only been surpassed in 2008. While the EZ is currently entering recession, we expect this to be mild and short rather than deep or long, but with downside risks. However, recessions have previously caused core inflation pressures to slow in the EZ and we look for downside surprises on inflation to help convince the ECB that they need to reverse some of the tightening. Forward guidance is unlikely to be as clear as the Fed however, both given differences of opinion within the ECB and also the tendency of the press conferences to avoid too much forward guidance or references to possible long-term estimates of policy rates. Thus, 2yr yields will come down through 2024, but it will likely be a step process as rate cuts are delivered – we look for 75bps of cuts. Though we forecast 2yr yields at 2.45% by end 2024 (Figure 4), the pace will slow given the uncertainty about easing in 2025.

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

Source: Continuum Economics 

For 10yr yields this is all crucial. Though the 10-2yr yield curve has become less inverted in recent months (Figure 5), it is still more inverted than 2000 or 2007 or 2008, which reflects breakeven inflation expectations view that the ECB 2% price objectives will be achieved in the future – we feel that the quarterly profile of CPI will get there in H2 2024. The arrival of ECB rate cuts will validate this view, but probably only means a marginal decline in 10yr yields. Thus, we project 2.35% 10yr yields end 2024 versus our projection of 2.60% for end 2023. The lack of transparency on the 2025/26 policy trajectory is one consideration, but it is unlikely that the ECB will be aggressive in easing rates and the market could worry that a 2.0-2.5% deposit rate could be the stopping point – especially as a weak recovery replace recession in 2024. Additionally, the era of ultra-low interest rates has ended, which includes a switch from QE to QT. One of the challenges for the long-end will be whether the ECB delays guidance on PEPP QT potentially starting from 2025 given ECB rate cuts being delivered and we are genuinely uncertain on this issue – as is the ECB! 

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

Source: Datastream/Continuum Economics

In terms of EZ sovereign spreads, the question is whether mild fiscal consolidation will continue to be followed at a national level, soothed by EU Next Gen funds providing some stimulus. At this juncture we feel that the political situation in Italy and Spain do not argue for a change of fiscal policy. Thus we see only a small widening of spreads, which reflects 10yr Bund yields coming down marginally, with little change in 10yr Italy or Spain. If the ECB decided to announce QT PEPP from early 2025, then this could lead to some late 2024 spread widening. Finally, we also remain focused on France, both given the huge buildup of debt since 2007 (here) and the huge holdings of non-French residents.

JGBs and Gilts 

For 10yr JGB yields, we see a process of the BOJ gradually allowing the effective cap on 10yr JGB yields to rise close to 1% by late 2023/early 2024. They do not want a sharp move to the new 1% cap and will likely undertake intermittent operations to allow 10bps adjustments upwards in yields. We forecast 0.80% 10yr yields by end 2023. The 2^nd stage of moving away from ultra-easy monetary policy will likely come in Q1 2024. We favor a rise of 10 to 20bps in the BOJ policy rate currently at -0.1% to end the era of ZIRP. Abandoning QE with YCC is less likely, as this could lead to a sharp rise in JGB yields and cause an interest rate shock to the economy. Before 2013, 10yr JGB yields were between 1-2%, despite the BOJ policy rate being at or close to zero (Figure 6). We are also below consensus on 2024 CPI inflation and feel that this will stop eventually the BOJ from being too aggressive. We forecast 0.95% for end 2024 for 10yr JGB yields. 

Figure 6: 10yr JGB and BOJ Policy Rate (%)

Source: Datastream/Continuum Economics

We feel that UK policy rates have peaked (here) and now the BOE will wait for elevated rates and a H2 recession to bring core and headline inflation down further and we forecast headline inflation falling below 2% by mid-2024. Restrictive policy rates can then give way to a cumulative 100bps of BOE cuts from Q2 2024 and this will mean a persistent decline in 2yr yields (Figure 7) to 3.7% by end 2024 – as the market anticipates more easing in 2025. Scope exists for a decline in 10yr yields to 4.00% by end 2024, reflecting UK inflation coming back towards target and also the decline in U.S. Treasury yields. However, the traditional process of less yield curve inversion should be evident in 2024, with a swing back to a small positive yield curve by end 2024.Additionally, we feel that the size of the ongoing BOE QT (£100bln pa pace) can keep long-end yields elevated.

Figure 7: CE BOE Bank Rate, UK 2yr and 10yr Yield Forecasts (%)

Source: Continuum Economics