U.S. 10yr Yields Higher Then Lower?

A lot of debate existing on whether 10yr U.S. Treasury yields will move still higher or are already high enough and will come down in 2024.What are the key issues and what will be the movement of 10yr Treasury yields? 

Figure 1: U.S. 10yr-2yr and U.S. Industrial Production Yr/Yr (%) 

Source: Continuum Economics/Datastream 

U.S. 10yr Yields Higher or Lower? 

U.S. 10yr yields have been rising consistently since the July FOMC meeting, both as the prospect for a further Fed hike remains real and as the Fed are signaling that policy will remain tight through H1 2024. The market has reduced expectations of rate cuts in 2024 and from the current Fed Funds rate only fully discounts a 25bps cut by the September 2024 FOMC meeting. The stickiness of core inflation, plus the soft landing in the U.S. economy, are helping to also restrain rate cut expectations. Indeed, in 2 and 3yr time money market futures are consistent with 4% Fed Funds rate rather than the Fed long-term estimate of neutral at 2.5%.

It is the soft landing issue that is causing a lot of debate. Some believe that lagged monetary policy will still throw the U.S. into recession, which will be followed by more Fed rate cuts than discounted and then lower 2yr and 10yr U.S. Treasury yields. Most of the market however feels that the incoming data is currently consistent with the soft landing narrative and that the 10-2yr yield curve should be less inverted or positive in this situation (Figure 1). 2005 shows that a soft landing could still see yield curve inversion, just less than currently. 

Some have countered that the 2yr Fed Funds discount is not currently as large as 2000 or 2007-08. While this is true, the 10yr U.S. Treasury yield to Fed Funds (Figure 2) does show the long-end is pretty stretched versus Fed Funds.

All of this has prompted increasingly bearish sentiment in the speculative community, with hedge funds targeting 10yr yields to 5.00-5.25% to get to a less inverted yield curve and until the Fed prepare the way for rate cuts (unlikely before the spring, unless surprisingly weak data is evident).

Figure 2: U.S. 10yr-Fed Funds Rate (%) 

Source: Continuum Economics/Datastream

However, the pessimism has prompted heavy short positioning by hedge funds and CTA. Though the pessimism could drive us to 4.75-5.00% 10yr yields in the near-term, end investors take the view that current yields provide the prospects for good medium-term returns. Additionally, the speculative community traditionally book profits and start to think about next year the traditional profit-taking phase in mid-October to mid-November, which could cause short covering in U.S. Treasuries.  Finally, the rise in the 10yr bond yields could push some FOMC members to argue for a delay or cancellation of the feared November 1 hike.  

Into 2024, we would see 10yr yields coming down. Firstly, while the switch to expecting an easing cycle does certainly mean less yield curve inversion, 10yr yields still tend to decline during this process (Figure 3) and we feel that this will be the key theme in H2 2024. Additionally, though we see U.S. core inflation settling around 2.5%, we feel that this does not mean that the U.S. easing cycle has to stop at 4% as currently discounted – though the terminal policy rate in the next easing cycle could still have a low 3 handle. Once the Fed actually cut rates the first time, the fixed income market will likely jump on the easing bandwagon and more aggressively discount rate cuts in the next few years.

Figure 3: U.S. 10yr, 2yr and Fed Funds Rate (%) 

Source: Continuum Economics/Datastream

It is also worth noting that 10yr real yields have jumped a lot in the last 2 years (Figure 4), as breakeven inflation expectations have been capped by the aggressive Fed policy tightening. Though they are not high in absolute terms compared to the pre GFC experience, this does point to a further tightening of financial conditions still to feedthrough the financial system and this in itself will likely reinforce core inflation going sub 3%.

Figure 4: U.S. 10yr Real Yields (%) 

Source: Continuum Economics/Datastream

Long-term investors also draw a contrast between the post 2012 and previous periods, given that the Fed dots and forward guidance started in 2012 and this provides a ballpark signal of Fed thinking on official rates. End investors are arguing that this transparency can allow the yield curve to be somewhat more inverted than in the past, as medium-term policy expectations are below current policy rates.

We would accept some of these counterarguments, but we feel that they will only become dominant once the Fed actually starts cutting the Fed Funds rate. We feel that this will be underway in H2 2024 and can allow 10yr yields to come down to 3.90% by end 2024 that we highlighted in the September Outlook (here), but most of the yield decline will likely come in this period. While the switch in attitudes on Fed policy can bring U.S. 10yr yields down in the medium-term, we would however say that the U.S. budget deficit and QT can keep 10yr yields more elevated than the consensus for end 2024 (here).