(Bloomberg) — US interest-rate strategists mostly expect that Treasuries will extend their recent rally, dragging yields lower and steepening the curve in the second half of 2023 so long as labor market conditions soften and inflation ebbs.
The most bullish forecasts among those published by primary dealer firms — including predictions from Citigroup Inc., Deutsche Bank AG and TD Securities — anticipate that the Federal Reserve will cut its overnight benchmark in 2024. Goldman Sachs Group Inc., which predicts that inflation will stay unacceptably high and that the US economy will avoid a deep recession, has the most bearish forecast.
In addition to the outlook for policy and inflation, expectations about Treasury supply are a key factor shaping forecasts. The supply of new US debt shrank in 2022 but could resume growing if the Fed continues to shed its holdings.
Following is a compilation of forecasts and year-ahead views from various strategists published in the final couple of months of 2022.
- Bank of America (Mark Cabana, Meghan Swiber, Bruno Braizinha and Ralph Axel, Nov. 20 report)
- “Rates will likely be headed lower, though the move will require further labor market softening and may not occur until later in 2023,” and risks to the outlook are more balanced
- “We expect the UST curve to dis-invert and move towards a positive slope”
- “A slowing economy, eventual Fed hiking pause, and lower vol should support UST demand,” while net coupon supply to the public should decrease
- Citigroup (Jabaz Mathai and Raghav Datla, Dec. 16 report)
- “There is scope for Treasuries to cheapen initially before a second half rally” takes 10-year yield back to 3.25% at year-end
- Assumes fed funds rate will peak at 5.25%-5.5% and market will price in cuts totaling 275bp from December 2023 to December 2024
- Forward-starting steepeners look attractive: “In terms of transition from the hiking cycle to on-hold and subsequent easing of policy, the potential for the forward curve to steepen as the cycle turns is one of the most promising areas of returns in 2023”
- Breakevens will continue to decline as inflation curve steepens; 10-year breakeven has scope to around 2.1%
- Deutsche Bank (Matthew Raskin, Steven Zeng and Aleksandar Kocic, Dec. 13 report)
- “While the cyclical peak in US yields is likely behind us, we are waiting for further evidence of weakness in the US labour market to switch to a long duration view”
- “US recession and Fed rate cuts will bring a steeper curve, though three factors will keep yields from declining further: ongoing inflation pressures calling for continued Fed policy restraint, a longer-run nominal fed funds rate of 3%, and higher term premia”
- “During periods of higher inflation and inflation uncertainty, bond and equity returns tend to be positively correlated. This reduces the hedging benefits of bonds, and bond risk premia should rise accordingly. Also, the increase in bond supply and reduction in central bank QE is resulting in a material shift in the supply/demand equation”
- Goldman Sachs (Praveen Korapaty, William Marshall and others, Nov. 21 report)
- “Our projections are substantially above forwards over the next six months, and we are looking for higher peak rates than we have witnessed thus far in this cycle”
- Reasons include: economy is likely to avoid a deep recession and inflation will be sticky, requiring restrictive policy for longer
- Also, “notable shrinkage in central bank balance sheets” will result in “increased supply to the public and a reduction in excess liquidity”
- JPMorgan Chase & Co. (Jay Barry and Phoebe White, Nov. 23 report)
- “Yields should fall and the long end should steepen once the Fed goes on hold, consistent with previous cycles,” expected in March at 4.75%-5%
- “Demand dynamics could remain challenging,” however, as QT continues, foreign demand reflects muted reserve accumulation and unattractive valuations, and commercial banks experience modest deposit growth; pension and mutual demand should improve but not enough to fill the gap
- Morgan Stanley (Guneet Dhingra, Nov. 19 report)
- Conclusion of Fed hiking cycle by January, moderating inflation and a soft landing for the US economy will drive yields lower gradually
- 2s10s and 2s30s curves will be steeper than forwards by year-end, with steepening concentrated in 2H
- Key themes include a shallower Fed path than the market expects (25bp cut in December vs market pricing cuts in 2024) and term premiums elevated by factors including concerns around the stickiness of inflation and Treasury market liquidity
- MUFG (George Goncalves)
- US rates, especially long maturities, “will have at least one more sell-off (driven by the remaining Fed hikes, a return of corporate issuance, ECB QT, euro-govie supply and the relaxing of BoJ YCC) before a proper move toward lower rates can begin”
- While other central banks raise rates, US curve “will see multiple rounds of mini bear steepening,” however “the curve won’t be able to dis-invert until the Fed is officially in an easing cycle:
- This created “opportunity to start to amass forward-starting curve steepeners in anticipation of cuts”
- NatWest Markets (Jan Nevruzi and John Briggs)
- With a recession likely in 2023 and expected terminal fed funds rate of 5% “well-priced, we look for yields to peak if they have not already”
- However bull-steepening is likely to be delayed relative to past cycles because inflation will be slow to return to target, forestalling Fed’s dovish pivot
- Favors forward-starting 5s30s steepeners and 10s30s real yield steepeners
- Outlook for Fed policy easing in early 2024, “Treasuries will be more attractive investments for both domestic and international investors alike”
- RBC Capital Markets (Blake Gwinn, Nov. 22 report)
- UST curve may continue bear-flattening during 1Q 2023, then terminal funds rate of 5%-5.25% and “a more sustained downshift in inflation” and expectations for rate cuts should allow “a shift to a friendlier environment for bull-steepening and duration exposure”
- Expects 50bp of cuts in H2 2023, with risks skewed toward more, in “a gradual return to neutral, rather than a large-scale easing cycle”
- Domestic demand for USTs should rebound as investors look to take advantage of historically high yields
- Societe Generale SA (Subadra Rajappa and Shakeeb Hulikatti, Nov. 24 report)
- Expects Treasury yields to gradually decline and yield curve to remain inverted in H2 then gradually steepen in H2 “as we look to a recession in early-2024,” delayed by tight labor market and healthy corporate profit margins
- Fed rate will reach 5%-5.25% and remain there “until the actual onset of a recession”
- TD Securities (Priya Misra and Gennadiy Goldberg, Nov. 18 report)
- “We expect another volatile year for rates, but see risks to duration as more two-sided”
- Fed likely to raise rates to 5.5%, maintain there for some time due “very gradually declining inflation backdrop,” and begin easing in December 2023 as labor market weakens
- “We think the market is underpricing the terminal funds rate as well as the magnitude of rate cuts in 2024, which is the thesis behind our SOFR H3-H5 flattener”
- End of Fed hiking cycle should improve demand for longer-dated Treasuries, which “provide liquidity and safety heading into a recessionary environment”
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