Close to a peak?

Since the beginning of the year, the continued acceleration of inflation has led central banks to sound increasingly hawkish, driving the yield on the 10-year US Treasury up sharply to 2.92% in early May and on its German Bund equivalent to 1.01%. This has triggered one of the worst year-to-date total return performances ever, at -11.3% for the 10-year US Treasury and -11.0% for the Bund on 4 May (in local currency).

The main driver of the rise in long-dated rates has been the market’s repricing of the terminal rate. Looking at futures curves, the market expects the fed fund rate to peak at 3.2% in 2023 and the European Central Bank (ECB)’s deposit rate to peak at 1.8% (on 4 May). Both these figures are above the central banks’ own terminal rates estimates and our forecasts. After peaking at around 3%, our central scenario (to which we ascribe 55% probability) is for the US 10-year yield to fall toward 2.6% in H2 as slowing inflation leads the US Federal Reserve (Fed) to tone down its hawkish rhetoric, and a slowdown in economic growth triggers a pause in its rate-hiking cycle.

Although the 10-year German inflation breakeven rate has shot up recently, we expect it to drop again in H2 as inflation falls. Our central scenario is for a 10-year Bund yield of 0.6% at year’s end after a short-term peak of around 1%. In alternative scenarios, we could see 10-year US and German yields rising to 3.0% and 1.2%, respectively, at year’s end if economic growth holds up well, or falling to 2.0% and 0.2%, respectively, should recessionary fears rise.

As for the Fed’s balance-sheet reduction, assuming it proceeds smoothly, the Fed could have a US Treasuries portfolio of about USD3,000 bn at end-2025 compared with USD5,300 bn today.

Coupled with fewer Fed’s rate hikes than the market is currently pricing, a slowdown in the US economy in H2 and a core inflation rate that remains above the Fed’s 2% average inflation target for some time (feeding retail investors’ interest in inflation-hedge instruments), we expect the 10-year TIPS to fall back to -0.3% by year’s end (compared with 0.5% on 4 May).

We see the German 10-year inflation-linked yield at -1.8% by year’s end, slightly higher than its current level ( -2.06% on 4 May), mostly because we believe the ECB will end its quantitative easing purchases in June and inflation will slow in H2. However, we expect the ECB to fully reinvest its maturing bonds. We see the risk of so-called ‘quantitative tightening’ as very remote in the euro area given the recent widening in euro periphery sovereign bond spreads over Bunds.