U.S. and EZ Government Bond Yields and Peaking Rates
Bottom Line: We feel that the Fed is getting close to peaking and the ECB has already peaked with the July rate hike. However, this is already priced into 2yr yields, with the current discount to policy rates, and we see 2yr U.S. Treasuries and Bunds to 4.8% and 3.05% by end 2023 respectively. Inverted yield curves also mean that the long-end has anticipated the multi quarter trend. Indeed, hopes for U.S. expansion continuing through 2024 will likely see a less inverted yield curve and we see 10yr Treasury yields at 4.10% by end 2023.10yr Bund yields are forecast to 2.6%, as the EZ economy only suffers a borderline recession.
Figure 1: 10-2yr U.S. Government Bond Curve (%)
Source: Datastream/Continuum Economics
Rate Hikes Ending But No Early Rate Cuts
Policy tightening is getting to a mature stage in DM economies, with the Fed and ECB now in restrictive territory and the lagged effects of previous tightening yet to fully feed through. Nevertheless, the scale of the inflation shock over the last couple of years, plus still elevated core CPI readings, means that a tightening bias remains for the Fed and the ECB.
In the Fed’s case, we still pencil in a final 25bps hike most likely at the November meeting (here), but this is truly data dependent and Fed policy depends on real sector data before the September 20 FOMC meeting. The U.S. economy has proved more resilient than expected and the market sees a soft landing with the U.S. avoiding a recession from the effects of Fed tightening. However, the effects on the economy and then on price and wage setting behaviour is uncertain (here) and the Fed & market will closely watch data to understand the true picture. This leaves the outlook for government bond yields in limbo. 2yr yields are at a moderate discount to the Fed Funds rate; this was larger in 2000-01 and 2007-08. However, the volatility of inflation this time will likely stop the discount widening until core inflation trends have fallen below 3% and appear to be heading lower – but getting down to 2% will be difficult (here). Our end year 2yr yield forecast remains at 4.8%.2yr yields will likely only come down consistently when easing moves from being a concept to speculation about a move in the coming meetings. It was noticeable in the Q/A to the July FOMC press conference that chair Jerome Powell was not pushing back against easing ideas for 2024 and did help to refine some thinking - e.g. that QT could continue with rate cuts and that Powell thought we can eventually get back down to 2.5% neutral rates. However, this is conceptual and the Fed chair was clear that we remain some way distant from more tactical considerations on easing.
This choppy elevated view for 2yr yields also has a strong influence on 10yr U.S. Treasury yields, as the curve remains steeply inverted (Figure 1). We feel that 10yr yields will likely remain choppy around current levels and actually we still forecast 10yr U.S. yields at 4.10% by end 2023. As it becomes clear that the U.S. has escaped a recession and managed to continue growing, we feel that the U.S. yield curve will become less inverted.
Meanwhile, for the EZ the story is a double dip borderline recession. The 2022 surge in gas and electricity prices caused a dip in Q4 2022 growth and then a flat Q1 2023, though import sluggishness meant that domestic demand was weaker. Now a 2nd slowdown is underway helped by the ECB tightening feeding through and we are forecasting -0.1% for Q3 2023 and zero for Q4 2024. This is not good, but is not bad enough to raise fears of a moderate recession. However, we would make two key points re policy prospects. Firstly, the slowdown in money and credit growth warns of a larger slowdown in the economy than embedded in our central forecasts and this could also help disinflation. Secondly, elevated wage growth in 2023 will likely slow in 2024, as the EZ labor market is not as tight as the U.S. judging by vacancies/unemployed ratio and this should help the core inflation trajectory. We have recently highlighted that leading indicators of core inflation point to downside prospects (here). On balance, we thus forecast no further rate hikes from the ECB, with the September meeting likely to still see a tightening bias but this likely disappearing by December.
2yr Bund yields are currently at a discount to the ECB deposit rate (Figure 2) and this is less than May 2023, but still somewhat stretched historically. We would suspect that 2yr Bund yields are unlikely to go to a deeper discount versus the ECB deposit rate, until the ECB starts preparing for rate cuts and this is a 2024 story. Our forecast for end 2023 is 2yr Bund yields at 3.05%.
Figure 2: 2yr-ECB Deposit Rate (%)
Source: Datastream/Continuum Economics
10yr Bund yields also remain more deeply inverted versus 2yr than 2000 and 2007-08 and for now this will likely be a restraint on the 10yr yield declining. If anything we see a sideways pattern with 10yr yields ending 2023 at 2.6%. Though an end to the ECB cycle will be helpful, the current inversion already anticipates this concept. Forecasts of economic recovery into 2024 will likely be enough to ensure that the yield curve becomes less inverted.
Figure 3: 10-2yr Germany Government Bond Curve (%)
Source: Datastream/Continuum Economics