With four 25 bps rate hikes on the cards this year and the Fed looking at reducing its balance sheet, we expect US Treasury yields to rise further in the coming months.
Thomas Costerg & Lauréline Renaud-Chatelain, Pictet Wealth Management.
At the end of the Federal Open Market Committee meeting on 26 January, the US Federal Reserve (Fed) indicated that it intends to start hiking rates in March, in line with pre-meeting expectations and stated that its quantitative easing programme would end in the same month. In addition, Fed Chair Jerome Powell hinted that rate hikes could be accelerated later this year if inflation remains high and there are further robust rises in wages.
Powell also confirmed that the Fed intends to kick off quantitative tightening (QT) soon after the first rate hike, alluding to the possibility that QT could coincide with future rate hike decisions. We expect an actual decision on QT in June. We forecast that monthly caps on securities redemptions will increase from USD 40bn in the first month of QT to a cruising speed of USD 80bn by September.
We now expect four 25 bps rate hikes in 2022 instead of three, and a further two 25 bps hikes next year. However, we still believe the Fed will want to keep nominal rates below the long-run level of inflation due to the constraints imposed by high federal and private debt and underlying concerns about how long the current expansionary phase of the economic cycle will last.
The Fed chairman brushed off the recent volatility in equity markets, asserting that the Fed’s focus is on the real economy. But we do not think this necessarily marks the end of the current market-friendly Fed regime. It may become more sensitive to what’s going on in the markets again later this year.
A balance sheet run-off this year coupled with Fed fund rate hikes could contribute to a further rise in long-term US real yields and lead to a slight steepening of the 10-to-two year slope of the US Treasury yield curve from 71 bps (on January 26) to 100 bps by the end of June.
Nevertheless, as is usually the case as a Fed hiking cycle progresses, we expect the US yield curve to start flattening in the second half of this year. However, we believe that more aggressive rate hikes from the Fed (such as a one-off 50 bps hike during H1) could cause the US yield curve to bear-flatten directly. The Fed’s hawkish turn is reducing the risk of runaway inflation, so we now expect market-based inflation expectations to stabilise around their current levels.
Our 10-year US Treasury yield forecasts remain unchanged at 2.1% for end-June and 1.9% by the end of the year. While we expect yields to rise in the coming months, we recently changed our stance on US Treasuries from underweight to neutral as we are mindful of their safe-haven status during periods of equity market volatility.
