Global Daily – How high will bond yields go?

by: Nick Kounis , Kim Liu , Bill Diviney

Global Rates View: We have revised our bond yield forecasts higher – We have revised our core government bond yield forecasts higher. Our base case sees 10y US Treasury yields at 3% at year-end (previously: 2.6%) and 10y German Bund yields at 0.95% (previously 0.7%). Government bond yields have risen more quickly and sharply than we expected at the start of the year. Expectations of a faster pace of policy rate hikes by the Fed and ECB partly explain the bond sell-off. However, we think that the term or risk premium in government bond markets has also made a comeback recently, reflecting multiple factors. The most important is higher inflation expectations, a phenomenon seen across a broad range of inflation securities, reflecting the rise in oil prices and strong economic growth. Second, supply-demand dynamics are increasingly becoming less favourable. The ECB has slowed the pace of asset purchases, the Fed is shrinking its balance sheet and the US fiscal expansion points to higher issuance of Treasuries and possibly upside risks to economic growth. Overall, the drivers look more significant in the US than the eurozone, but the cross-market correlation has put substantial upward pressure on Bund yields as well.

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We think the drivers behind some of these trends are well-founded and will stick and hence we have raised our bond yield forecasts. Firstly, markets have moved earlier than we thought to price in the strong economic environment and exit from accommodative monetary policy, though some rise in yields was justified on this basis. Second, we have raised our trajectory for Fed funds hikes (see below) and there are still upside risks. Third, the deterioration in the US public finances could also add some upward pressure on bond yields, though the impact is unlikely to be very large.

Compared to current levels, the further rise government bond yields we expect is relatively moderate. This reflects our view that underlying inflationary pressures will rise only gradually and moderately. In the US, wage growth is likely to accelerate, but we expect a trend upswing in productivity growth and a softening of shelter inflation to dampen core inflationary pressures. In the eurozone, we still see slack in the eurozone labour market and this should keep a lid on wage growth for some time to come. In addition, we think the ECB will hike interest rates later than markets are currently pricing. Furthermore, euro core bond supply remains moderate. Finally, US Treasury yields are not far off from the level that the Fed signalling to be the eventual peak in its policy rates. In recent cycles, yields have tended to peak at those levels. (Nick Kounis & Kim Liu)

Fed View: A steeper rate hike profile – We now expect the Fed to hike interest rates three times this year in March, June and September, and twice next year in March and June. Previously we projected two rate hikes in both 2018 and 2019, in June and December. While we continue to expect core inflation to remain modestly below target this year, stronger growth prospects, accelerating wages, and higher inflation expectations should give the Fed greater confidence to continue hiking at a quarterly pace for the time being. However, with inflation unlikely to respond immediately to higher wage growth this year, we expect the Fed to pause in its hiking cycle at the December meeting. Once inflation begins to more meaningfully respond to wage pressures in 2019, we expect the Fed to resume rate hikes, with a further two pencilled in for March and June – taking the upper bound of the Fed funds rate to 2.75%, around the long-term neutral rate (as in the December FOMC projections). The risk to our forecast is tilted towards a further hike in Q4 in 2018, particularly if wage growth accelerates to the highs that prevailed in 2007-8 (around 3.5%), which would suggest an overheating labour market. (Bill Diviney)