We have seen significant moves in US yields and rates over the past couple of weeks and the uncertainty is where we are heading over the next couple of months and quarters. In principle, we see three main drivers for longer dated yields and rates: supply, QE from the Fed and the business cycle outlook.
We argue that 10Y US treasury yields and 10Y USD swap rates will edge lower towards 0.50% over the next couple of month as the economy stays under pressure and Fed QE supports the bond market. However, on a 6M to 12M horizon, we expect yields to move higher again as the economy improves. A better economy would allow the Fed to let yields drift slightly higher. We have 6M and 12M forecasts of 0.8% and 1.0%, respectively, for 10Y US treasury yields.
1. Supply is booming
The US has put in place a wide range of both fiscal and monetary measures. This week the White House and Congress agreed a USD2.0trn stimuli package. The stimuli package comes in a situation where the US economy is heading for a very deep recession, so we expect a significant decline in taxes on top of the extra fiscal spending
Hence, we expect the US supply to rise significantly in 2020 and coming years. The exact funding need is very difficult to estimate before we have more details of the package. Furthermore, we expect a significant part of funding to be in T-bills. However, even if T-bill issuance secures a significant part of the funding, there is little doubt in our minds that under normal circumstances such a large jump in US treasury supply would push yields and rates higher across the curve.
2. QE is open-ended and could outpace supply
The Federal Reserve has been very forceful in its response to the crisis. Not only has it cut rates to zero, it has also opted for open-ended QE. Hence, the Fed can buy as many US treasuries and mortgage bonds as it wants. Given that the Fed needs to have as low, longer dated yields as possible to get the full impact of the monetary stimuli, we believe the Fed will be very determined to keep yields low. Low treasury yields and purchases of mortgage bonds work to keep mortgage yields in check, which is an important part of the general easing conducted by the Fed.
We assume that the Fed will continue to be a dominant buyer in the bond market for several years and that this will be the most important factor in keeping yields and rates from rising.
3. 3M USD Libor rates to fall back
For USD swap rates, there is an issue with USD Libor fixings, which have stayed high despite Fed funds being cut to zero. If this becomes the new standard, US swap rates could over time rise relative to government bond yields (wider asset swap spreads). So far, the market is pricing this as a temporary issue. The reason is the Fed initiatives, where liquidity is increased rapidly in the US money market through QE, repo operations and various target facilities.
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