USD yields peaking now, potential ECB rate hike in May

The banking turmoil that erupted in the wake of the collapse of Silicon Valley Bank (SVB) five weeks ago has subsided as a market theme as the string of negative news has come to a halt. As a result, with traditional stress indicators declining, the focus has increasingly moved to the macro narrative, as we also discussed in our previous Yield Outlook - Uncertainty about US banking sector clouds rate outlook, 17 March.

The ‘normalisation’ of the rate outlook means that markets are currently trading two major themes which we also expect to set the tone for rates markets in coming months. While ‘Dollar Land’ is already discussing the first US rate cut, we expect the Federal Reserve to deliver a final 25bp rate hike at the upcoming May meeting and then to keep policy rates unchanged until Q1 24, when a gradual rate cutting cycle will likely commence. As regards the eurozone, discussions about rate cuts are still premature. We continue to expect a further string of rate hikes, with a 50bp hike in May followed by 25bp hikes in both June and July, bringing the peak policy rate to 4%. This is somewhat above the current market pricing of a 3.75% peak policy rate. The biggest risk to our forecast of a 4% peak policy rate hike is whether the ECB will deliver a 25bp or a 50bp rate hike in May. Markets are currently pricing 32bp for May. The economic backdrop for our central bank calls is presented in the Nordic Outlook - Unchartered territory, 4 April.

As a result, we see longer-term USD yields peaking ‘now’ and expect them to stay around current levels until autumn this year before starting to decline gradually, reflecting the expected easing cycle in 2024. The USD curve is currently heavily inverted due to markets expecting the Fed to start easing monetary policy as early as this summer. At the time of writing, markets are pricing three rate cuts of 25bp each between June and December this year. While we do not share this view, we do not expect a significant repricing posing considerable upside risk to longer-term USD yields, as markets are focusing on the next big move in rates markets, which is likely to be for lower rates. Historical evidence shows that, on average, the Fed has started cutting policy rates three quarters after the last rate hike. We currently expect a first rate cut from the Fed in Q1 24 followed by a sequence of cuts at a pace of one cut per quarter through 2024. This should likely support the lower rates narrative starting in autumn this year in anticipation of monetary policy easing.

As for the eurozone, we continue to see modest upside risk to longer-term yields on a 3M horizon in a curve flattening move, as the ECB is yet to show a strong hand in fighting the high underlying inflation prints, taking the front end up relative to the long end. We expect eurozone markets to start discussing and pricing 2024 rate cuts from the ECB towards the end of this year, trailing US markets slightly. This is likely to support longer-term yields on 6M-12M horizons. We project an ECB rate cutting cycle starting in summer 2024.

While the very high volatility in rates markets we observed one month ago has subsided somewhat, volatility has remained at elevated levels, and markets are currently pricing 10Y EUR swap rates in a broad 3.5 percentage point range by the end of our projected horizon (with a 90% probability).

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