An end to the rise in US long-term rates?

The bond correction that followed the deflationary shock of the 1st wave of COVID started in the summer of 2020 and has continued almost steadily until now. The yield on the 10-year T-Note has thus risen from just over 0.50% in August 2020 to over 3.00% recently (with a sharp acceleration between early March and late April).

As the table below shows, this makes the total bond correction close to the sharpest in 41 years (i.e., since long rates have been falling), notably those of 1987 and 1994.

Source: Bloomberg

Why is this so? Because it seems to us that among the fundamental determinants of long rates (expected monetary tightening, expected inflation, size of the Fed’s balance sheet, risk appetite, global savings/investment balance, etc.) as well as among the technical factors (term premium, investor positioning, cyclically-adjusted yield curve), the bulk of the upside factors are behind us.

What about the outlook for monetary tightening? Clearly, this has been the main driver of yields recently. And it seems to us that we are close to the high point of repricing.

Futures markets are now pricing in a terminal rate of 3.20%: the market’s expectation of a rate well above the neutral rate envisaged by the Fed (2.4% in the medium term). Similarly, as shown in the chart below, it is higher than a nominal neutral rate based on an equilibrium real neutral rate of 0.5% and the inflation rate envisaged by the FED at the end of 2023 (2.6%).

It should be remembered that increases in short rates only have an impact on long rates if they are not anticipated. Long rates discount (always one step ahead) future monetary tightening. This is why bond corrections precede the start of monetary tightening (half of the bond correction occurs before the start of actual monetary tightening) by a median of 4 months since the early 1980s.

As for the reduction of the balance sheet envisaged by the Fed (QT, Quantitative Tightening), it is not only earlier than in 2017-18 compared to the 1st rate hike (2 years at the time vs. 2/3 months envisaged now) but it is also going to be very intense. According to the proposals put forward by the Fed, the reinvestment of the spillover effects of the securities purchased under QE should indeed decrease rapidly. Thus, only amounts above a cap (increasing over 3 months) will be reinvested (caps of USD 60 bn per month for Treasuries and USD 35 bn for MBS).

The caps are significantly higher than at the time of the 2018 balance sheet reduction (USD 30 bn for Treasuries and USD 20 bn for MBS). For Treasuries, there is a fairly clear picture of the balance sheet decline that this induces (USD 300 bn in 2022, USD 600 bn in 2023). The total pace of balance sheet decline, including MBS, is expected to reach around USD 900 bn in 2023, almost double that observed in 2018/2019 (around USD 500 bn annualised).

If we take into account the traditional effects of QE on long-term rates (around 20bp for USD 600 bn of asset purchases according to an average of studies), adjusted for the increase in Treasuries outstanding since the 2010-2016 period, we would end up with an impact of around 20bp on the equilibrium 10-year long-term rate. But here again, market expectations for the QT are, according to surveys, very close to those of the Fed. Consequently, the risk of a surprise is reduced.

On inflation expectations, there are still some risks of upside surprises given the difficulties in terms of value chains (China, especially after the containment measures affecting the port of Shanghai) and, of course, the conflict situation in Ukraine, but we still believe that prices will fall back from Q3.

It is worth noting that the global trend is for inflationary surprises to level off with macro dynamics slowing (see chart below).

For the rest, the almost flat yield curve and a very low term premium seem to us to be in line with the trend and ongoing slowdown of the US economy.

As for the positioning of investors, it seems to us to be quite aggressive.

Thus, investors have a fairly low weighting of bonds in their portfolios (0.4 standard deviations below the average vs. almost 1 standard deviation above at the beginning of 2020). Similarly, speculative positions are now very bullish.

This is why we can expect the US 10-year T-note to peak at just over 3% (just over 1.00% for the 10-year Bund) in the coming weeks, followed by a lower level at the end of the year. It should be noted, however, that the volatility of Treasuries will remain particularly high and that the trajectory may be bumpy in the coming weeks.