In this note, we take a closer look at the recent move and the outlook for US yields. We decompose long yields into 1) a term-premium and nominal interest rate expectations and 2) into break-even inflation and real rates
We argue that the risk is till skewed to the upside for long US yields, and we now expect 10Y US treasury yields to reach 3.50% over the next three to six months compared to our earlier 3.25% target.
A further move higher in 10Y US yields is in our view supported by several factors.
1. The macro-economic backdrop is still constructive going into 2019
2. Fed is on auto-pilot until June 2019 where the 3% level will be reached. After 3% is reached, we believe it is more 'stop and go' for the Fed, as further hikes depend on how the economy is doing and how markets are reacting to monetary tightening. At least we expect the Fed to hike once more in H2 19 (i.e. a total of four times from now until year-end 2019).
3. We expect a further move higher in the US term-premium as supply and demand factors increasingly become bond negative. We expect supply of bonds will, on the one hand, continue to rise in 2019 due to fiscal expansion and a growing refinancing need. On the other hand, demand from foreign investors will be put under further pressure as the FX hedging costs will continue to rise. We also see room for a general lift in US interest rate volatility . Inflation risks have become more pronounced and long-yields are no longer capped at 3%, which seemed to be the market view until recently. The latter adds to interest rate uncertainty in the US.
4. Real rates have started to move higher over the past couple of months in financial markets. Given the economic healing, revisions to real rates estimates and focus on the Fed going 'above neutral' real rates could be pushed further up in 2019.
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