UBS House View Daily

Thought of the day

01.09 - Is the bond bull market back?

10-year Treasury yields dropped 17 basis points in August to 2.12%, the steepest monthly decline since June 2016 and close to the 2017 low of 2.08% reached earlier this week. The drop in yields may reflect safe haven bids on North Korea tensions, low expectations for Fed rate hikes and benign inflation – August core PCE of 1.4% released August 31 was still well below the Fed’s official 2% target.

But the decline may be overdone and we see a number of reasons why yields should gradually rise:

  • Though periodic flare-ups over North Korea may continue, our base case remains for a diplomatic solution. US Defense Secretary James Mattis said August 31 that the US is "never out of diplomatic solutions. ”
  • The market may now be too pessimistic about the chances of further Fed rate increases. With the labor market strong and financial conditions relatively loose, we believe rates will rise faster than current market pricing of just two further 25 basis point hikes in the next three years.
  • We expect the Fed soon to announce a start date for balance sheet reduction, possibly as early as the September FOMC meeting. Shrinking the balance sheet has the potential to push bond yields higher.

So we believe market expectations will need to adjust to a higher rate trajectory and Treasury yields should gradually strengthen. Our six-month forecast for 10-year yields is 2.5%. We also believe 2-year yields could rise from 1.3% to 1.8% over six months.

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