U.S. Yield Movements and Prospects for Bunds/JGB’s

Though rising U.S. yields since the summer had dragged up government bond yields elsewhere, 10yr government bond spreads became wider versus the U.S. for other major DM government bond markets.  This has now started to reverse after last week yield drop and what are the prospects into 2024? 

Figure 1: 10yr U.S.-JGB Yield and 10yr U.S.-Bunds (%)  

Source: Datastream/Continuum Economics 

Government bond markets have seen noticeable drops in yields over the past week, as a partial reversal to the rise seen since July.  However, it is still worth reflecting on the forces behind the previous rise to look at prospects in the near-term and into 2024.  The rise in U.S. 10yr yields since the summer had dragged long-dated yields higher in other major DM government bond markets, but the 10yr spreads for Bunds and JGB’s have not matched U.S. Treasuries (Figure 1).  Over the past few months this goes beyond the normal partial reaction of other major government bond markets and reflects views on fiscal and monetary policy.  

Figure 2: Key DM Government Debt/GDP Trajectories (%)  

Source: IMF/Continuum Economics 

One of the issue for U.S. Treasuries has been the large size of the deficit (Figure 2) combined with persistent Fed QT that has pushed long-dated yields higher.  In contrast, the EZ and UK are on slow fiscal consolidation paths, while Japan fiscal policy consolidation is planned to stop by mid-decade.  On monetary policy, the soft landing of the U.S. economy has brought into question whether the U.S. government bond curve should be less inverted or positive.  In EZ and UK the recession is arriving in the economic data (here) and this validates inverted yield curves, until central banks start cutting interest rates.  The ECB (here) and BOE (here) have already peaked on official rates in contrast to the remaining modest Fed hawkish bias (here), due to these differences in economic numbers.  EZ inflation is also coming back into control, as the recession weakens inflation pressures as it did in 2007 and 2011.  We project that the ECB will likely cut key policy rates by 75bps in 2024 starting in Q2 2024, though the ECB may only signal the first move just before it happens given their poor forward guidance.  

However, fears of further Fed tightening has given way to a sense that the Fed has peaked after the November 1 FOMC meeting (here) and weaker than expected October U.S. employment report.  High 2yr U.S. yields had dragged 10yr yields, but a mood shift is now underway that can see the market discount more Fed cuts in 2024 and also questioning the soft landing narrative.  We look for a soft Q4 and then sub 1% quarterly numbers in 2024 and this could see 10yr yields dipping below our 4.50% end 2023 10yr yield projection, as hedge funds are squeezed out of more shorts in the coming weeks.  

Even so, only really recession like U.S. data or early hints of 2024 easing from the Fed would likely trigger a more substantive near-term decline in yields from current levels.  The inverted yield curve also argue against too large a fall in 10yr yields from current levels.  Indeed, this inverted yield curve, plus the ongoing large supply from the budget deficit and QT will likely stop 10yr yields from falling too far in 2024.  The Fed will also be slow to start easing with weaker rather recessionary data and we now only look for 50bps of cuts in 2024.   Consequently, we have revised our end 2024 10yr U.S. yield forecast up to 4.25% versus 3.90% previously.   For 2yr U.S. government bond yields we see a more noticeable fall to 4.1% as the market looks ahead to more Fed easing in 2025 and we see further yield curve disinversion through 2024 before the 10-2yr U.S. curve turns positive in late 2024.   

Meanwhile, the actual delivery of 75bps ECB easing will be important to 2yr yields coming down in the EZ and also clearly driving the traditional shift towards a positive yield curve for Bunds.  However, the ECB will likely provide less visibility on further policy easing into 2025 then the Fed and we forecast 2yr Bund yields down to 2.35% by end 2024.  This means that the 2yr U.S. Treasury-Bunds yield spread should actually narrow marginally to 175bps by end 2024.  

Figure 3: 2yr U.S.-Bunds and Fed Funds to ECB Deposit Rate (%)  

Source: Datastream/Continuum Economics 

Despite the fall in 2yr Bunds yields, 10yr Bund yields will likely only drop modestly by end 2024 to 2.40% despite more ECB easing than the Fed.  The level of real yields using 10yr index linked bonds is lower at 0.02% for 10yr Bunds versus 1.66% in the U.S.  EZ government bond yields have adjusted a long way from negative nominal yield levels, but in an easing cycle will likely see less of a decline than normal due to the still low level of real yields for Bunds and OATs.  Italy could see some spread narrowing versus Bunds however, though this will be restrained by Italian fiscal policy.  10yr U.S.-Bund yield spread can stabilise after the recent narrowing, but as the U.S. economic data weakens in Q4 (here) the prospect is that the spread could narrow marginally into 2024 and reach 185bps by end 2024.  Overall, the main action should be falling 2yr yields moving mostly ion tandem in the U.S. and Bunds.      

In contrast, the 2yr U.S. Treasury to JGB spread can narrow into 2024 (Figure 4), as the market becomes more comfortable about 2024 and 2025 Fed easing prospects.  Money market futures discount a terminal policy rate of just below 4% from the Fed in 2 and 3yr, which we feel is too high.  Though we feel that the neutral policy rate has increased due to the fiscal deficit, we are pencilling in 2.75% long-term.  Further Fed easing will likely be required to avoid real interest rate increases and we forecast the end 2025 Fed Funds rate at 3.88% and end 2026 at 2.88%, which the market will become more comfortable in thinking about in H2 2024 when Fed easing has started.  We see 2yr U.S. yields at 4.1% by end 2024.  

In contrast, the BOJ is preparing to lift the policy rate from -0.1% in spring 2024, given the BOJ has surprised three times on the 10yr JGB yield cap and reference rate (here) and the market is discounting a policy rate of +0.1 to +0.2% by late 2024 and more tightening into 2025. This could be a false dawn for BOJ tightening like the 2000 and 2006 tightening cycle when the BOJ policy rate rose a cumulative 25bps and 50bps respectively only to subsequently reverse.  However, for H1 2024 the BOJ determination and the 1st hike will likely dominate and this points to the prospect of some narrowing of 2yr bond spreads between the U.S. and Japan from the Japanese side in early 2024 before a spring pause and then further narrowing from the U.S. side in H2 2024.   

Figure 4: 2yr U.S.-JGB and Fed Funds to BOJ Policy Rate (%)  

Source: Datastream/Continuum Economics 

10yr JGB yields can push well through 1% in H1 2024 if as expected the BOJ end yield curve control (YCC) given that it is effectively allowing much more flexibility already.  The BOJ will likely intermittently smooth or protest at 10yr JGB yield rises via bond buying operations, but this is not QE. By H2 2024, we can see 10yr JGB yields in the 1.5-2.0% region, as the end of YCC can mean that end investor demand at auctions will remain weak until the 10-2yr yield curve reaches at least the 150-175bps seen in 1999 and 2004 (here).  QT though remains a distant prospect in Japan, as it risks a still steeper yield curve and a major interest rate shock to the Japanese economy, which would be too aggressive for the BOJ – it took the Fed 3 years after the end of QE3 to start QT in 2017.  Given our forecast of U.S. 10yr yields at 4.25% by end 2024, this could see the 10yr U.S.-JGB spread narrowing to around 250-260 bps.