Treasury strategists expect lower yields and a steeper curve in 2023

(Bloomberg) – U.S. interest rate strategists mostly expect Treasures to extend their recent rally, dragging yields lower and steepening the curve in the second half of 2023 as long as labor market conditions soften and inflation falls.

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The most optimistic forecasts among those published by major traders – including forecasts from Citigroup Inc., Deutsche Bank AG and TD Securities – predict that the Federal Reserve will cut its benchmark index overnight in 2024. Goldman Sachs Group Inc ., which predicts that inflation will remain at an unacceptable level and that the US economy will avoid a deep recession, has the most bearish forecasts.

Along with the policy and inflation outlook, expectations for cash supply are a key factor shaping the forecast. The supply of new US debt has declined in 2022, but could resume growth if the Fed continues to shed its holdings.

Below is a compilation of forecasts and outlooks for the year ahead from various strategists released in the last two months of 2022.

• Bank of America (Mark Cabana, Meghan Swiber, Bruno Braizinha and Ralph Axel, November 20 report)

  • “Rates are likely to fall, although this move will require further labor market easing and may not occur until late 2023,” and the risks to the outlook are more balanced.

  • “We expect the UST curve to disinvert and move towards a positive slope.”

  • “A slowing economy, possible Fed pauses and lower volume should support US demand,” while net coupon supply to the public is expected to decline

• Citigroup (Jabaz Mathai and Raghav Datla, December 16 report)

  • “Treasures may depreciate initially before a second-half rally” brings 10-year yield down to 3.25% at year-end

  • Assumes the fed funds rate will peak at 5.25%-5.5% and the market will price in cuts totaling 275 basis points from December 2023 to December 2024

  • The steepenings from the front look attractive: “In terms of the transition from the bullish cycle to the hold and subsequent policy easing, the potential for the futures curve to steepen as the cycle turns is one of the most promising yield areas in 2023.”

  • Break-even points will continue to fall as the inflation curve steepens; The 10-year balance has a range of approximately 2.1%

• Deutsche Bank (Matthew Raskin, Steven Zeng and Aleksandar Kocic, December 13 report)

  • “While the cyclical peak in US yields is likely behind us, we await further evidence of weakness in the US labor market to shift to a long-term view.”

  • “The U.S. recession and Fed rate cuts will lead to a steeper curve, although three factors will keep yields from falling further: continued inflationary pressures calling for continued Fed policy restraint, a nominal 3% longer-term federal funds and higher term premiums.”

  • “During periods of higher inflation and inflationary uncertainty, bond and equity returns tend to be positively correlated. This reduces bond hedging benefits, and bond risk premia should increase accordingly. Moreover, the increase in the supply of bonds and the reduction in central bank QE lead to a significant change in the supply / demand equation.

• Goldman Sachs (Praveen Korapaty, William Marshall and others, November 21 report)

  • “Our projections are significantly higher than expected over the next six months, and we are looking for higher peak rates than we have seen so far in this cycle.”

  • Reasons include: the economy is likely to avoid a deep recession and inflation will be sticky, necessitating tighter policy for longer

  • In addition, “a significant contraction in central bank balance sheets” will result in “an increase in supply to the public and a reduction in excess liquidity”.

• JPMorgan Chase & Co. (Jay Barry and Phoebe White, November 23 report)

  • “Yields should fall and the long end should steepen once the Fed is on hold, consistent with previous cycles,” expected in March at 4.75%-5%

  • “Demand momentum may remain challenging,” however, as QT continues, foreign demand reflects subdued reserve accumulation and unattractive valuations, and commercial banks are seeing modest deposit growth; demand for pensions and mutuals should improve but not enough to close the gap

• Morgan Stanley (Guneet Dhingra, November 19 report)

  • The end of the Fed’s hike cycle by January, subdued inflation and a soft landing for the US economy will lead to a gradual decline in yields

  • The 2s10s and 2s30s curves will be steeper than the forwards by the end of the year, with steepening concentrated on 2H

  • Key themes include a shallower than market-expected Fed path (25bp cut in December from market price cuts in 2024) and elevated term premiums by factors such as rigidity concerns Inflation and Treasury Market Liquidity

• MUFG (Georges Gonçalves)

  • US rates, especially long maturities, “will have at least one additional selloff (driven by remaining Fed hikes, a return to corporate issuance, ECB QT, Euro-govie supply and the BoJ YCC easing) before a proper move to lower rates can begin.

  • As other central banks hike rates, the US curve will “see several bearish mini-slope cycles,” but “the curve cannot reverse until the Fed is officially in an easing cycle:

  • This created “the opportunity to start accumulating curve stiffeners from the front in anticipation of cuts”

• NatWest Markets (Jan Nevruzi and John Briggs)

  • With a recession likely in 2023 and a terminally ill fed funds rate expected at 5% “well-assessed, we expect yields to peak if they haven’t already”

  • However, the ramp-up should be delayed relative to past cycles as inflation will take time to return to target, preventing the Fed’s dovish pivot

  • Favors early start 5s 30 steepers and 10s 30 real yield steepers

  • Outlook for Fed policy easing in early 2024, “Treasuries will be more attractive investments for domestic and international investors”

• RBC Capital Markets (Blake Gwinn, November 22 report)

  • The UST curve may continue to flatten in the first quarter of 2023, then the terminal funds rate from 5% to 5.25% and “a more sustained decline in inflation” and expectations of rate cuts should allow “a shift to a more favorable environment for upside and exposure duration”

  • Expects 50bp declines in H2 2023, with risks tilted higher, in “a gradual return to neutrality, rather than a full-scale easing cycle”

  • UST domestic demand set to rebound as investors seek to take advantage of historically high yields

• Societe Generale SA (Subadra Rajappa and Shakeeb Hulikatti, November 24 report)

  • Expects Treasury yields to gradually decline and the yield curve to remain inverted in the second half, then gradually steepen in the second half “as we eye a recession in early 2024”, delayed by a market tight labor and healthy profit margins for businesses

  • The Fed rate will reach 5% to 5.25% and will remain there “until the actual start of a recession”

• TD Securities (Priya Misra and Gennadiy Goldberg, November 18 report)

  • “We expect another volatile year for rates, but we see duration risks as more two-sided.”

  • The Fed is expected to raise rates to 5.5%, hold them for a while due to a “very gradually falling inflation backdrop” and start easing them in December 2023 as the labor market weakens

  • “We believe the market is undervaluing the terminal funds rate as well as the magnitude of rate cuts in 2024, which is the thesis behind our H3-H5 SOFR flattening.”

  • The end of the Fed’s hike cycle should improve demand for longer-dated Treasuries, which ‘provide liquidity and safety as we approach a recessionary environment’

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