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Treasury strategists expect lower yields and steeper curve in 2023

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(Bloomberg) — U.S. interest rate strategists mostly expect Treasuries to extend their recent rally, dragging yields lower and steepening the curve in the second half of 2023, provided job market conditions ease and inflation decreases.

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The most optimistic forecasts among those published by primary brokerages – including forecasts from Citigroup Inc., Deutsche Bank AG and TD Securities – anticipate that the Federal Reserve will lower its benchmark overnight in 2024. Goldman Sachs Group Inc., which predicts that inflation will remain unacceptably high and that the US economy will avoid a deep recession, has the most pessimistic forecast.

In addition to the policy and inflation outlook, expectations about the Treasury supply are a key factor in shaping forecasts. The supply of new US debt has shrunk in 2022, but could grow again if the Fed continues to unload its holdings.

Below is a compilation of forecasts and visions for the year ahead from various strategists published in the final months of 2022.

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

    • “Rates are likely to come down, although the shift will require further labor market easing and may not come until late 2023,” and risks to the outlook are more balanced

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

    • “A slowing economy, eventual Fed pause and lower volatility should support UST demand”, while the net supply of coupons to the public is expected to decline

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

    • “There is room for Treasuries to go cheap initially before a second-half rally” takes the 10-year yield back to 3.25% at the end of the year

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

    • Early tilters look enticing: “In terms of transitioning from the walk-to-hold cycle and subsequent policy easing, the potential for the future curve to steepen as the cycle turns is one of the most promising areas for returns in 2023”

    • Breakevens will continue to decline as the inflation curve slopes; The 10-year breakeven point is scoped to around 2.1%

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

    • “While the cyclical peak in US yields is likely to be behind us, we are awaiting further evidence of weakness in the US labor market to shift to a longer view”

    • “The US recession and Fed rate cuts will bring a steeper curve, although three factors are preventing yields from falling further: ongoing inflationary pressures requiring continued Fed policy easing, a nominal long-term federal funds rate of 3% and higher term premiums”

    • “During periods of higher inflation and inflationary uncertainty, bond and stock returns tend to be positively correlated. This reduces the bond’s hedging benefits, and the bond’s risk premium should rise accordingly. Furthermore, the increase in the bond supply and the reduction in central bank QE are resulting in a significant shift in the supply/demand equation.”

  • Goldman Sachs (Praveen Korapaty, William Marshall et al, November 21 report)

    • “Our projections are substantially above the future for the next six months, and we are looking for higher peak rates than we have witnessed so far this cycle”

    • Reasons include: the economy is likely to avoid a deep recession and inflation is persistent, requiring restrictive policies for longer.

    • Furthermore, “remarkable shrinkage in central bank balance sheets” will result in “increased supply to the public and reduced excess liquidity”

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

    • “Yields should decline and the long end should rise once the Fed is lifted, consistent with previous cycles,” expected in March at 4.75%-5%.

    • “Demand dynamics may remain challenging,” however, as QT continues, external demand reflects 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 completion of the Fed’s hike cycle in January, inflation moderation and a soft landing for the US economy will gradually reduce yields

    • 2s10s and 2s30s curves will be steeper than the front until the end of the year, with a steepness concentrated in the 2H

    • Key themes include a shallower Fed path than the market expects (25bp cut in December versus market price cuts in 2024) and elevated term premiums on factors including concerns over inflation stickiness and market liquidity of the treasury

  • MUFG (George Gonçalves)

    • US rates, especially long maturities, “will have at least one more sell-off (driven by the Fed’s remaining hikes, a return to corporate issuance, ECB QT, euro-govie offering and the easing of the BoJ YCC) before a proper move towards lower rates can begin.”

    • While other central banks raise rates, the US curve “will have several rounds of mini-low slopes”, however “the curve will not be able to de-invert until the Fed is officially in an easing cycle:

    • This created “opportunity to start accumulating early curve leans in anticipation of cutbacks”

  • NatWest Markets (Jan Nevruzi and John Briggs)

    • With recession likely in 2023 and federal funds rate expected at 5% “with good pricing, we expect yields to peak, if they haven’t already”

    • However, the rise is likely to be delayed from previous cycles, as inflation will take time to return to target, avoiding the Fed’s dovish pivot

    • Favors Advanced Start 5s30s incline boosts and 10s30s True Yield Boosters

    • Outlook for Fed policy easing in early 2024: “Treasury bonds 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 through the first quarter of 2023, so the 5%-5.25% terminal funds rate and “a more sustained reduction in inflation” and expectations of rate cuts should allow for “a shift to a more friendliest environment for high and long exposure”

    • Expects 50 basis points of cuts in the second half of 2023, with risks headed for more, in “a gradual return to neutral rather than a full-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, November 24 report)

    • Expect Treasury yields to gradually decline and the yield curve to remain inverted in the second half, then gradually rise in the second half “as we look for a recession in early 2024”, delayed by the tight job market and margins. healthy corporate profit

    • Fed rate will hit 5%-5.25% and stay there “until the real onset of a recession”

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

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

    • The Fed will likely raise rates to 5.5%, holding them there for some time due to the “very gradual declining inflation backdrop” and will start to ease in December 2023 as the job 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 smoother”

    • End of Fed bull cycle should improve demand for longer-term Treasuries, which “provide liquidity and security in a recessionary environment”

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