Treasury yields could drop back, but remain structurally higher

The 10-year US Treasury yield rose from a low of 3.31% on 6 April to 4.34% on 21 August, the highest level since 2007, primarily driven by higher real yields. This reflected, in part, more resilient-than-expected US economic activity, which opened the door for higher-for-longer US Federal Reserve (Fed) policy rates. The downgrade of the US’s credit rating by Fitch at the start of that month against the backdrop of a surge in the federal government’s deficit as well as the Bank of Japan’s (BoJ) tweak of yield curve control around the same time also contributed to the increase in long-term US yields.

Both the postponement of our call for a US recession from H2 this year to H1 next year in our scenario as well as the likelihood of a structural increase in the term premium lie behind our decision to raise our year-end forecast for the 10-year US Treasury yield from 3.5% to 4% (still lower than the 4.26% yield at time of writing). But the 10-year yield could end the year lower than our new forecast if recession fears take hold in the market sooner than we expect. It is against this backdrop that we remain overweight US Treasuries. 

Due to our expectations for negative economic growth in H1, along with decelerating inflation, we expect the Fed to start cutting policy rates at the end of Q2 2024, with a total of 150bps of cuts in the Fed funds rate by the end of next year. This compares to the 90 bps of cuts currently being priced in by the futures market (on 8 September). 

The term premium is a key component in any assessment of the future direction of the 10-year Treasury yield. A number of factors are likely driving the extra yield that investors have been demanding recently for holding longer-dated US debt. These include the uncertainty surrounding the country’s fiscal trajectory. They also include increasing deficits, which could lead to ever-increasing Treasury supply, as well as greater macroeconomic volatility. Disputes over the federal budget for 2024 could lead to a government shutdown if no agreement is reached by 1 October 2023, bringing the erosion of fiscal governance in the US back into focus and could ensure a structurally higher term premium than in the recent past. In addition, the 2024 presidential and congressional elections will help set the path for US budgetary policy and will also help decide how high the term premium is.