Bonds’ roller-coaster ride may not be over yet

Bond market volatility returned with a bang in March. Market participants repriced forecasts for the path of central banks’ policy rates sharply lower as failures among US regional banks brought home the fragilities caused by the rapid increase in rates over the past year. The two-year US Treasury yield fell from a peak of 5.06% on 8 March to a low of 3.76% on 5 April.

These sharp whipsaws in yields are signs of market uneasiness about the state of the US economy. Although US households have been holding up so far, specific sectors like real estate (as well as regional banks) face real challenges. Together with the US Federal Reserve (Fed)’s rate hikes, tighter lending conditions are likely to cool down the US economy. 

Futures markets see a 50-50 chance of an additional 25 bp Fed rate hike in May but are pricing more than three 25 bps rate cuts by the end of this year. For our part, our central scenario is that the Fed will not raise rates in May but that it will not cut rates this year either. This is mostly because we see core Personal Consumption Expenditures inflation in the US remaining well above the Fed’s 2% target throughout this year. 

If our central scenario plays out (we assign a 55% probability to it), then market anticipations for rate cuts this year are premature, opening up the possibility for the two-year US Treasury yield to rebound to slightly above 4% by year’s end. But we believe the 10-year yield could remain within its recent 3-4% range. We are therefore sticking with our year-end forecast of 3.5% for the 10-year US Treasury yield.

Although we believe that the Fed’s recent liquidity measures and its full guarantee of three failed banks’ deposits may lower the likelihood of a full-blown credit crunch (a complete halt of banks’ and capital markets’ lending to the real economy), we still foresee a credit squeeze (a slowdown in lending). Even if US Treasury and other core sovereign bond yields (they remain tightly correlated) rebound in the coming weeks due to stabilisation in the banking sector, our year-end forecast of 3.5% for the US 10-year US Treasury yield and 2.5% for its German counterpart therefore still faces downside risk. 

In view of the US’s uncertain economic prospects, we have been extending duration to maturities in the 7-10 year range within our overweighting of US Treasuries in general. Both the safe-haven status and higher interest rate sensitivity of long-dated US Treasuries could help them protect portfolios in the event of a credit crunch. 

Stickier core inflation in the euro area means we are maintaining our neutral stance on core euro area government bonds. Although market turmoil is usually global, we see less likelihood for ECB rate cuts. This could limit the downside for the 10-year German Bund yield (probably to slightly below 2% from 2.2% on 5 April) and as such the potential protection provided by long-dated core euro sovereign bonds.