Peak in long rates in sight

Rates View: Front-loaded rate hikes to drive rates higher, but not for long 

The market repricing which we already expected in our previous rates outlook (see here) to trigger a bond sell-off recently occurred setting rates higher in Q3. Indeed, the market ramped up its rates expectations on the back of ongoing and accelerating inflationary pressures pushed up expectations of terminal rates to levels even in excess of our base case. As such, we do not expect rates to move too far from current levels in the near term and to rather come down as we approach the end of this year. As such, we judge the peak in the US and EU rates is not long way off now. We expect a peak around the end of this quarter/ beginning of Q4, while we see clear decline in yields from the end of this year and especially next year.

US rates: Treasury bonds set to rally in 2023

After the recent development in the US economy and inflation, we now expect the FOMC to front-load rate hikes and to reach its peak earlier. We expect the fed funds (upper) rate to peak at 4% in December instead of February. Thus, we expect the 10y Treasury yield to peak a few months prior to the final rate hike as long-term rates already more than reflect those rate hikes and the 4% final rate.

Thereafter, we expect Treasury yields to slide from the year-end onwards. Multiple factors are in play here. First, we expect US inflation to cool off with the economy to start showing signs of weakness approaching the end of the year and throughout H1 2023. Thus, we expect rising risk-off sentiment to increase safe-haven demand pushing Treasury yields lower. Second, we expect the Fed to cut interest rates next year as well as in 2024 to come back to the neutral level at 2.5%. Overall, this will lead to lower rates in 2023 and particularly in Q1 2023 where we expect the market to price in additional rate cuts as it currently set the Feds fund rate to reach 3.5% end of 2023 versus 3% in our forecast.

EU rates: Deeper economic recession expected to move EU rates lower

As we expect the eurozone economy to face a deeper economic recession than in the US we expect EU rates to fall more significantly than US rates. However, since inflation in the Eurozone remains elevated due to soaring energy prices, we have raised our ECB deposit rate to 2% for the end of the year. As such, we expect the curve to bear-flatten as short-term rates will reflect higher ECB rate while we expect the longer-end of the curve to slide on the back of the downturn in the economy. Indeed, we expect Bund yields to start falling in Q4 2022 as we get weaker economic indicators which are likely to trigger a flight-to-quality. Combined with the US spill over effects and the pricing out of one or two 25bp rate hikes from the market, we expect Bund yields to drop from Q4 onwards. Furthermore, we expect the market to undershoot our forecast levels and to price in a few rate cuts for 2023 and 2024 which will also add up to the downward pressure on Bund yields, particularly on the front-end of the curve. As such, we expect the 2y Bund yield to drop slightly below the 1% level again by Q2 2023.

Once the economy shows signs of stabilisation with improving economic and market conditions, we expect the market to shift to a risk-on mode again moving Bund yields higher in H2 2023. As such, we expect the Bund curve to bull-steepen in the second part of next year with Bund yields reaching the neutral level at around 1.5% as we expect the ECB cut rates to this level in 2024.