DM Rates Outlook: Peak Rates and Yield Curve Steepening

• EZ 2yr yields are unlikely to fall much further until the ECB cuts rates, but we do not see this occurring until 2024 – we feel that ECB rates have already peaked. Long-end yields will remain low through mid-year, but then will start to rise as the recession ends and 2024 recovery hopes grow. Traditional yield curve steepening can reinforce the rise in long-dated yields and we see 10yr Bund yields at 2.6% by end 2023.
• The outlook for 10yr JGB yields depends on the next adjustment of the BOJ yield cap. BOJ Ueda will likely be cautious, but does want to steepen the yield curve to reduce the adverse side effects of QE with yield curve control. A 25bps hike in the cap is likely at the September or October BOJ meeting. Thus we forecast 10yr JGB’s at 0.75% for end 2023.

Risks to our views: A moderate U.S. recession on larger than expected tightening of financial conditions could bring forward Fed rate cuts and prompt a downward shift in 2yr yields, but similar yield curve steepening between 10-2yr.

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

Source: Continuum Economics

Peak Fed Rates and Then Easing 

The Fed has correctly taken the view that the U.S. regional bank crisis (here) will curtail lending and hurt the U.S. economy and help the move back to target inflation rates. However, unless the bank crisis reignites, the Fed bias remains towards one more hike and then not cutting until 2024, as core inflation is too elevated to be confident of a return to the core PCE inflation target (here). Only a moderate recession would deliver rate cuts earlier. This leaves the U.S. yield curve inverted and 2yrs are at a large discount to the Fed Funds rate. 

2yr yields reflect expectations that rate cuts will start in H2 2023. Given our view of no cuts until 2024, this makes it difficult for 2yr yields to go much lower in the next 3-6 months and we see 2yr yields at 3.90% by end 2023. We see 75bps of rate cuts being delivered through 2024 and this will allow 2yr yields then to come down further, as hopes grow for 2025 rate cuts as well. We see 2yr yields at 3.30% by the end of 2024. 

Though the eventual decline in short-dated yields is helpful for the long-end, it will likely be overwhelmed by traditional yield curve steepening out of the bottom of a recession or major slowdown. This process has already started during March, with the major adjustment at the short-end. The experience from 2000 and 2007 (Figure 2) shows that this yield curve steepening trend can be powerful. It will also be reinforced by the ongoing reduction in Fed holdings of U.S. Treasuries at $60bln pm. Though the Fed regard this as benign, we still feel that it does impact demand/supply balance in U.S. Treasuries and will keep long-dated yields elevated. Finally, though the Fed will have success in getting core PCE inflation lower, it will be difficult to get down from 3% to 2%. Moreover, once the recovery builds in 2024/25, we could be back in a position of tight labor markets in a few years.

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

Source: Continuum Economics

Overall, we see 10yr yields at 4.00% by the end of 2023, as recession fears fade and the market looks towards recovery. The remainder of 2023 should be volatile at the long-end. As well as the regional bank crisis and shifting Fed views, the debt ceiling will only get resolved with a drama in the market and this could mean a temporary spike in U.S. Treasury yields before a deal is struck and the market goes back to looking at inflation/economy and banking.

We forecast 4.00% for the end of 2024, as this yield level will counterbalance upward forces from yield curve steepening but downward forces from the Fed actually cutting interest rates. What is clear to us is the yield curve steepening trend and we look for 10-2yr to be +50bps by end 2024. 

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

Source: Continuum Economics. 

Eurozone Debt Yields and ECB Tightening 

Government bond yields have fallen a lot in March on the banking sector problems. While we do not see a systemic crisis in the EZ banking sector (here), most banks will likely tighten credit standards even further and this will amplify the effects of ECB rate hikes. We feel that the ECB is making a policy mistake and overtightening, with rate hikes, Eur1.7trn of repos roll offs and APP QT. However, current yield levels now discount such a lower rate peak and then pivot from the ECB. Thus our 3 month view (Figure 4) is similar to current yields.

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

Source: Continuum Economics 

Thereafter, 2 and 10yr yields will likely go their own way.2yr yields will remain at a discount to the o/n rate and deposit rate, as hopes remain of 2024 rate cuts. Even so, we would find it difficult to see 2yr yields going to a more aggressive discount, as the EZ recession is likely to be shallow and by H2 some recovery signs will be evident. Additionally, the ECB will initially fight ideas that it has overtightened and this is a restraint on easing hopes. We can see German 2yr yields at 2.35% by end 2023. ECB rate cuts will then arrive in H1 2024 and this allow a further decline in 2yr yields as expectations grow that the deposit rate could come back down to 2% eventually. Thus end 2024 we are forecasting German 2yr yields at 2.1%.

10yr yields will have a different profile. Though 10yr yields can remain around current levels over the next 3 months, we would see scope for 10yr German yields at 2.6% by end 2023. Recovery hopes into 2024 will likely see the traditional yield curve steepening process out of the bottom of the recession and this will hurt the long end. The process in 2024 will be similar with further yield curve steepening and rising yields in the U.S. dragging up yields in Europe. Additionally, ECB tightening is also the large TLTRO repo roll offs and APP QT, which will sap demand at the long-end and are also a factor behind our 10yr yield forecast of 2.8% by end 2024.

Eurozone sovereign spreads will likely remain close to current levels in the next 3 months, but then gradually widen. We forecast 10yr Italy-Germany at 195bps end 2023 and 210bps for end 2024.This is not really on worries about the fiscal position however, but rather a rise in long-dated U.S. Treasury and Bunds yields spilling over to drag Italian yields higher. A 10yr Bund yield rise traditionally see some widen in 10yr spreads. The rise is only modest however, as the Italian funding position continues to be helped by receipt of EU next gen funds and this means little net issuance. The ECB APP rundown at EUR15bln is a modest force pushing up spreads and in Italy should mean extra gross purchases of EUR25bln are required by other players this year instead of ECB reinvestment. Meanwhile, though banks could be less willing to buy government paper with unrealized losses, Italian banks have reduced government bond holdings in the last year and thus the impact on future demand will be modest rather than large. What would be a concern would be the ECB accelerating the pace of APP runoff to EUR25bln, but this is less likely after the banking turbulence during March.

JGBs and Gilts 

The outlook for 10yr JGB’s depends on the guidance from the BOJ under Ueda and then when the 10yr yield cap is next adjusted. Ueda’s natural caution argues for later rather than sooner and thus the April and June meeting will likely see a cautious BOJ. We would see the greatest risk around the September and October meetings, as the BOJ does appear to want a steeper yield curve to reduce the adverse side effects of QE with yield curve control. However, Japanese banks hold Y212trn of Japanese government bonds and would suffer heavy unrealized bond losses and banking sector tensions if the BOJ abandoned QE with YCC. Thus we see an adjustment of the 10yr yield cap to 0.75% and then the BOJ aggressively ensuring that this is the last adjustment in the foreseeable future. We forecast 10yr JGB yields at 0.75% end 2023 and end 2024. 

The BOE bank rate has peaked at 4%. Additionally, we see 75bps of 2024 rate cuts as BOE policy is too tight, given the net fiscal tightening (frozen income tax allowances; lagged feedthrough of higher mortgage rates and lingering effect from still high retail utility bills). This will restrict the recovery profile into 2024. This can cap the rise in 2yr yields to 3.5% by end 2023 (current yield discount a lot of easing) and then fall to 3.3% as the rate cuts kick in. This may not help 10yr yields, given the traditional yield curve steepening out of a bottom of a recession.

10yr Gilts have overcome concerns about the government debt/GDP trajectory with Chancellor Hunt helping to reestablish long-term credibility. However, the BOE target of £80bln per annum reduction in holdings is aggressive and comes with gilt sales. Additionally, the 23/24 budget deficit still remains large and this is behind the DMO projection of £124bln of net issuance. Thirdly, some UK pension funds are reassessing their holdings of gilts, as the September turmoil has prompted questions of whether their LDI strategies makes them overweight fixed income compared to where they should be. Thus we see 10yr gilt yields as needing to be closer to the U.S. then in recent years. We see 10yr yields at 3.80% end 2023 and 4.00% by end 2024.

Figure 5: CE UK Bank Rate, 2yr and 10yr Yield Forecasts (%)

Source: Continuum Economics