Treasury yields seen as heading down by year’s end

Expecting a lot of near-term volatility, we remain neutral on US government bonds for now.

The 10-year US Treasury yield remains highly volatile, but it has fallen recently from a peak of 3.47% in mid-June to 3.09% on 29 June against a backdrop of continued US Federal Reserve (Fed) hawkishness.

Judging by policy-rate futures, market participants expect the Fed to hike rates to 3.6% in 2023 and then cut them as they start pricing in the risk of a US recession. However, we believe the Fed’s terminal rate will be closer to 3% and expect a mild recession in the US next year. So in our central scenario, to which we assign a 55% probability, we still expect the 10-year yield to fall to 2.6% by the end of the year.

Nevertheless, we expect the Fed’s communications to remain very hawkish until US inflation shows clear signs of falling. This means the 10-year US yield could remain within a volatile 3.0-to-3.6% range for some time. As the Fed’s terminal rate is usually a good anchor for the 10-year yield in a hiking cycle, the latter is likely to keep moving in line with market participants’ expectations for the policy rate path.

Given the uncertainty about the resilience of the US economy and the high volatility of Treasury yields, we can envisage two alternative scenarios. Both involve the Fed hiking to 3.8% by early 2023, as signalled in the latest Fed ‘dot-plot’ survey. The more upbeat of these alternative scenarios, to which we assign a 35% probability, is for the 10-year yield to reach 4.0% by the end of 2022 as the US business cycle continues to hold up well. The other scenario, to which we assign a 15%, is for the 10-year yields to slump 2.4% on the back of a severe US recession that involves major turmoil in financial markets.

For now, we remain neutral on US Treasuries. Even though our central forecast is for the 10-year yield to fall towards 2.6% by the end of the year, it is likely to remain above 3% and volatile until US inflation falls. 

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