Bumpy road ahead for US Treasuries

Volatility to stay high, but we expect 10-yields to decline from their current level later this year.

While it rallied in the aftermath of Russia’s invasion of Ukraine, hawkish communications from the US Federal Reserve (Fed) mean that the 10-year US Treasury yield is still considerably higher than at the start of the year, while the US 10-to-two-year yield curve has inverted.

Our central scenario (to which we assign a 55% probability) is for the Fed to hike rates gradually, albeit with a one-off 50 bps hike in May, and then to pause in H2 as inflation falls and US economic growth slows down. This could lead to the 10-year US Treasury yield falling from 2.38% on 1 April to 2.1% by the end of the year. In the short term, however, the 10-year Treasury yield could hover around 2.5% as the Fed threatens to hike rates by 50 bps several times and growth data remains solid.

As inflationary pressures ease, we expect the 10-year inflation breakeven rate to fall from its elevated level of 2.8% on 1 April towards 2.6%. Although we expect the 10-year US Treasury Inflation-Protected Securities (TIPS) yield to rise from -0.44% on 1 April towards -0.3% by June (underpinning our forecast of 2.5% for the 10-year nominal yield in June), we expect the 10-year real yield to fall back to -0.5% later this year as economic growth slows and the Fed becomes less hawkish. As both are key drivers of long-term real yields, growth rates and Fed policy should ensure the 10-year TIPS yield remains negative this year.

In our alternative, more positive, scenario (20% probability), US economic growth could remain robust, leading to a stronger rise of the 10-year US Treasury yield to 2.5% by the end of the year. In our negative scenario (25% probability), we see it falling to 1.9% in response to a sharp slowdown in economic growth.

We maintain our neutral stance on US Treasuries despite the sharp recent increase in yields as we expect yields to fall back in H2. Despite the considerable uncertainty about the lagged economic effects of higher yields, we still see US Treasuries as good (albeit costly) protection in the event of economic growth slowing.

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