As per CIO, the recent upward momentum in yields has been spurred largely by technical factors and should be reversed. (UBS)

The decline appeared partly due to a broader rally in safe-haven assets, following the Hamas attack on Israel over the weekend and the threat that this could escalate into a broader regional conflict and disrupt oil prices.


Considerable uncertainty remains over several underlying forces guiding the Treasury market, including the outlook for government bond issuance, the economically neutral level of fed funds rates, and the term premium the rate of compensation demanded by investors for holding longer-term over shorter-term bonds.


But, in our view, the recent upward momentum in yields has been spurred largely by technical factors and should be reversed:


Top Federal Reserve officials have hinted that the tightening of financial conditions resulting from rising yields may reduce the need for further rate hikes. Even after Tuesday’s decline, the 10-year yield is still around 50 basis points higher than at the start of September. This restricts credit conditions and has contributed to a rise in the Goldman Sachs US Financial Conditions index to the highest level since last November, one that indicates a net drag on the economy.


This point was underlined by Dallas Fed President Lorie Logan, who said on Monday that “if long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate.” The comments were more impactful since President Logan has been among the more hawkish policymakers in advocating the need for continued tightening. Fed Vice Chair Philip Jefferson said the central bank could “proceed carefully” with any further hikes, and also suggested higher bond yields were doing part of the central bank’s job for them. Following the comments, markets roughly halved the probability of a rate increase at the Fed’s November policy meeting to around 14%, based on the CME Group’s FedWatch estimate, and also scaled back the chances of a hike at the December meeting.


The threat of higher rates for longer could also be receding, as higher yields restrain growth. The September dot plot, which charts the rate expectations of top Fed officials, pointed to just 50 basis points of easing for 2024, down from a 100 basis points in the prior June release. That added to concern that the Fed would feel it was necessary to keep rates elevated well into 2024 to curb inflation. Recently, the fed funds futures market has moved to price in faster easing in 2024, with four 25-basis-point cuts during the year, up from three at the time of the Fed’s last meeting.


Inflation worries remain anchored, which bodes well for high-quality bonds. Much of the momentum behind the recent rise in bond yields has come from technical factors, including quantitative tightening from the Fed and the high level of bond issuance by the US Treasury, in our view. We have not seen an increase in inflation expectations—which would be a more sustainable driver of higher yields—and the 10-year breakeven rate of inflation has remains relatively steady. It currently stands at 2.31%, consistent with the Fed hitting its 2% target.


The next focus for investors we see will be the release of the September Consumer Price index on Wednesday. Another top Fed official, Michael Barr, expressed optimism that the central bank had made “significant progress” on “bringing inflation toward the direction we want.” Despite data on Friday showing double the pace of employment growth economists had expected for September, Barr said that supply and demand factors were coming “into better balance.”


So, recent developments support our view that yields should move lower over the coming 6–12 months. Against this backdrop, we are most preferred on fixed income. We recommend investors consider buying high-quality bonds in the 5–10-year maturity range. We foresee further cooling in inflation and slower global growth. Our 12-month forecast for the 10-year US Treasury yield is 3.5% in a base case, 4% in an upside scenario, and 2.75% in a downside scenario, which includes a US recession.


Main contributors: Solita Marcelli, Mark Haefele, Vincent Heaney, Christopher Swann, Matthew Carter, Alison Parums


Read the original reportYields do part of the Fed’s tightening task, 10 October 2023.