Tapering and slowdown pointing in opposite directions for yields

We expect market attention in the coming months to remain focused on 1) whether the spike in inflation is in fact temporary, 2) whether economies and GDP growth have peaked and 3) whether central banks will seriously begin to signal tapering of bond purchases in 2022.

However, the economic outlook has become muddier, and recent developments in China could potentially send shockwaves through global financial markets and push long yields down in the coming months.

Nevertheless, in our view, the combination of still high ongoing inflation, the continuing pick-up in the US economy, and a tapering decision by the US central bank (the Fed) is likely to put upward pressure on long US yields, in particular, in the next three months, leading us to expect US 10Y Treasury yields to hit 1.5% by the end of the year.

We expect an initial US rate hike to be on the cards late 2022 or so and the upward pressure on yields to remain in place. Hence, we expect US 10Y yields to hit 2% in 12 months’ time.

Higher US yields should tend to push European yields higher, and we are maintaining our 12-month forecast of 0.1% for German 10Y yields.

Muddier outlook for fixed income markets

Coming months are likely to see several factors clearly pointing in opposing directions for global long yields.

Pulling in one direction are the central banks, who are now looking beyond the pandemic. Both the ECB and the Fed are likely to buy fewer bonds in the market in 2022 than they have in 2021. An initial US rate hike is also beginning to put its head above the horizon, with the market pricing the first hike in early 2023. Inflation and, not least, inflation expectations are continuing to tick up, particularly in Europe as bottlenecks emerge in more and more markets. We also see increasing signs of wage growth picking up in some countries, including the US.

Pulling in the opposite direction are increasing worries that the global economy may shift down a gear after the strong growth fuelled by the reopening in the spring and over the summer. Much attention is focused on China and the problems plaguing the Chinese property giant Evergrande. Rising commodity prices, meanwhile, are creating concern that household purchasing power may be eroded, which would hit consumer speding and, ultimately, economic growth. Bottlenecks and their impact on inflation may mean we are heading for a stagflation scenario of high inflation and low GDP growth. Fears are also increasing about Covid-19 potentially hampering growth. We see rising infection rates in some countries with high vaccination ratios, like the UK and Israel, while Asia continues to experience lockdowns due to virus outbreaks, plus vaccine rollouts in Asia are lagging.

We expect market focus during the remainder of the year to shift between the factors supporting higher yields and those that point to lower yields. In other words, the picture has become somewhat muddier in recent months. Looking 6 and 12 months ahead, we still expect the global economy, and particularly the US economy, to continue to grow, with an initial rate hike moving steadily closer. We should also see fewer bond buybacks from both the ECB and the Fed. Overall, this would tend to push long yields higher both in the US and in Europe. We continue to expect US 10Y Treasury yields to rise to 2% and 10Y Bund yields to return to 0.1% on a 12M horizon. In the next two sections, we consider in more detail the likely short and long-term drivers of global fixed income markets.

Central banks looking beyond the pandemic

As always, we expect central banks will play a key role in both the European and US fixed income markets in the coming 12 months. Essentially, both the ECB and the Fed are moving – cautiously – away from the extraordinary policy easing via bond buybacks that was introduced last year during the pandemic.

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