Treasury strategists expect lower yields in 2023, a steeper curve

(Bloomberg) — U.S. interest rate strategists expect Treasuries to extend their recent rally, largely as labor market conditions soften and inflation eases, pushing yields lower and steepening the curve in the second half of 2023.

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The most bullish forecasts among those published by major dealer firms, including forecasts from Citigroup Inc., Deutsche Bank AG and TD Securities, expect the Federal Reserve to cut the overnight rate in 2024. It has the lowest forecast that it will remain unacceptably high and that the US economy will avoid a deep recession.

In addition to policy and inflation forecasts, expectations about the Treasury supply are a key factor shaping forecasts. The supply of new US debt has eased in 2022, but could continue to rise if the Fed continues to shed its holdings.

Below is a compilation of 2022 predictions and outlooks for the year from various strategists published over the past few months.

Bank of America (Mark Cabana, Meghan Swiber, Bruno Braizinha and Ralph Axel, November 20 report)
- “Culturals are likely to decline, although this move would require further softening of the labor market and may not occur until late 2023,” and the risks to the outlook are more balanced.
- “We expect the UST curve to shift and move towards a positive slope”
- “A slowing economy should ultimately support demand for a pause in the Fed’s hike and lower volume UST,” the net coupon supply to the public should decline.
Citigroup (Jabaz Mathai and Raghav Datla, December 16 report)
- “There’s scope for an initial selloff in Treasuries ahead of second-half rally” 10-year yield returns to 3.25% by year-end
- It assumes the Fed funds rate will peak at 5.25%-5.5% and the market is pricing in a 275-barrel cut from December 2023 to December 2024.
- Steepeners starting to look attractive going forward: “The potential for forward curve steepening as the cycle turns is one of the most promising revenue areas in 2023, given the transition from hiking to waiting and the subsequent easing of policy.”
- Interruptions will continue to narrow as the inflation curve steepens; The 10-year loss covers about 2.1%
Deutsche Bank (Matthew Raskin, Steven Zeng and Aleksandar Kocic, December 13 report)
- “While the cyclical peak in US earnings is behind us, we expect further evidence of weakness in the US labor market to move into the longer-term view.”
- “A US recession and Fed rate cuts will result in a sharper curve, although three factors will prevent yields from falling further: continued inflationary pressures will require Fed policy restraint, a longer-term nominal Fed funds rate of 3% and higher term premiums does”
- “In times of higher inflation and inflation uncertainty, bond and equity returns tend to be positively correlated. This reduces the hedging benefits of bonds and the bond risk premium should increase accordingly. Also, an increase in bond supply and a decrease in central bank QE results in a significant shift in the supply/demand equation.”
Goldman Sachs (Praveen Korapaty, William Marshall et al., November 21 report)
- “Our forecasts are significantly higher than the forwards over the next six months, and we’re looking for higher peak rates than we’ve seen so far this cycle.”
- Reasons include: the economy will avoid a deep recession and inflation will be sticky, requiring more restrictive policies
- Also, a “significant reduction in central bank balance sheets” would result in “increased supply to the public and reduced excess liquidity.”
JPMorgan Chase & Co. (Jay Barry and Phoebe White, reporting Nov. 23)
- Expected at 4.75%-5% in March “Yields should fall and tighten for a long time after the Fed goes on hold, consistent with previous periods”
- “Demand dynamics may remain challenging,” but as QT continues, external demand reflects weak 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, November 19 report)
- The end of the Fed’s hike cycle by January, inflation adjustment and a soft slowdown for the US economy will gradually lower yields
- 2s10s and 2s30s curves will be steeper by the end of the year than forward, with the sharpening concentrated in 2H
- Key themes include a shallower Fed path than the market expected (a 25bp cut in December and a cut in market prices in 2024) and term premiums pushed higher by factors including concerns about inflation stickiness and treasury market liquidity.
MUFG (George Goncalves)
- US rates, especially longs, “driven by remaining Fed hikes, return of corporate issuance, ECB QT, euro-govie proposal and BoJ YCC easing) “will have at least one more sell-off. lower rates may begin”
- Even as other central banks raise interest rates, the US curve will “see several rounds of mini-bearish tightening,” but “will not be able to invert the curve until the Fed officially enters a period of easing:
- This created an “opportunity to start picking up curved spikes that move forward in anticipation of cuts.”
NatWest Markets (Jan Nevrouzi and John Briggs)
- With the possibility of a recession in 2023 and an expected terminal feeding funds rate of 5%, “due to good pricing, we are looking for returns to peak, if they haven’t already.”
- However, the bull run is likely to be delayed relative to past periods as inflation will be slow to return to target, preventing the Fed from dovish.
- Forward starting 5s30s and 10s30s favor real profit erectors
- Forecast for Fed policy easing in early 2024, “Treasuries will be more attractive investments for both domestic and international investors”
RBC Capital Markets (Blake Gwinn, November 22 report)
- The UST curve may continue to flatten into the first quarter of 2023, after which a terminal funds rate of 5%-5.25% and expectations of a “more sustained downward slide in inflation” and rate cuts “allow for a transition to a more favorable environment for bulls to intensify and last.” should give “disclosure”
- A 50bp cut is expected in the second half of 2023, with risks pointing more in the direction of a “gradual return to neutral rather than a period of broad-based easing”.
- Domestic demand for USTs should pick up again as investors seek to take advantage of historically high yields
Societe Generale SA (Subadra Rajappa and Shakeeb Hulikatti, November 24 report)
- It expects Treasury yields to gradually decline and the yield curve to remain inverted in H2, then gradually steepen in H2 “as we expect a recession in early 2024,” delayed by a tight labor market and healthy corporate profit margins.
- The Fed rate will reach 5%-5.25% and will remain there “until the recession actually starts”.
TD Securities (Priya Misra and Gennady Goldberg, November 18 report)
- “We expect a more volatile year for rates, but view long-term risks as more ambivalent”
- The Fed is likely to raise rates to 5.5%, stay there for a while due to a “very gradual backdrop of declining inflation,” and begin easing in December 2023 as the labor market weakens.
- “We think the market is underestimating the terminal funds rate as well as the magnitude of rate cuts in 2024, which is the thesis behind our SOFR H3-H5 adjuster”
- The end of the Fed’s hiking cycle should improve demand for longer-dated Treasuries, which “provide liquidity and safety in a recessionary environment.”