Uncertainties feed into higher Treasury yields

The US 10-year yield has risen substantially since September, briefly touching 5% on 23 October (before retreating to 4.76% on 1 November). Contributing to this surge have been market participants’ expectations for ‘higher-for-longer’ policy rates and the fast increase in the term premium (the compensation that investors require for the extra risk entailed in holding longer-term bonds) in reaction to economic uncertainties and a growing US fiscal deficit.  Regarding the 10-year term premium, fiscal uncertainty is likely to remain high in the US as a federal budget for the 2024 fiscal year has yet to be agreed. This factor, along with the high net supply of US Treasuries and still elevated macroeconomic uncertainty could push the term premium further up.

Overall, a possible decline in long-term policy rate expectations that is offset by a higher term premium could mean the 10-year US Treasury yield at the end of December is closer to 4.5% than to our September prediction of 4%.  Longer term, the 4.3% policy rate expected by market participants in 10 years’ time looks aggressive. Our base case is that the US Federal Reserve (Fed) is done with its hiking cycle, especially as US economic growth could slow in the coming months. This could progressively push market participants to lower their longer-term expectations for policy rates.

While there is upside risk to our forecasts for US economic growth and the Fed funds rate, the recent widening of credit spreads and fall in equity indices point to tightening financial conditions. If this continues and triggers a recession at some point, the safe-haven status of US Treasuries could come back into focus, helping to bring the term premium back down. However, the surge in US Treasury supply could still mean the premium remains positive.