Article | Zhang Tao and Lu Siyuan (Financial Market Department of China Construction Bank, the article only represents the author's viewpoint)
Before looking forward to the US bond market this year, we need to first look back at the outlook for the beginning of last year. At the beginning of 2023, our outlook for the US bond market mainly includes three points:
Firstly, according to the policy expectation path of the Federal Reserve, the yield of short-term US Treasury bonds with a maturity of less than one year should follow the policy interest rate and further increase to over 5%.
Secondly, the longer the Federal Reserve maintains the endpoint interest rate above 5%, the faster the process of economic recession in the United States, and the corresponding long-term US bond yields are easy to fall but difficult to rise. Therefore, it is highly likely that the peak of 10-year US bond yields will be above 4.3% in October 2022.
Thirdly, before the Federal Reserve releases a clear policy turn signal, the degree of inversion of the US Treasury yield curve will continue to deepen.
Contrary to expectations, the reality of the US bond market in 2023 is:
One is that the yield on the one-year US Treasury bond has risen from a peak of 4.74% at the beginning of the year to 5.56%, and closed at 4.78% at the end of the year, with a minimum of 4.03% for the year - in line with our expectations.
Secondly, the 10-year US Treasury yield has risen from a peak of 3.88% at the beginning of the year to 5.02%, with a year-end closing of 3.87% and a year low of 3.25% - significantly exceeding our expectations.
Thirdly, the degree of inversion in the yield of 10-year and 3-month US bonds has increased from -74BPs at the beginning of the year to -190BPs, with the narrowest range reaching -62BPs during the year and closing at -152BPs at the end of the year; The degree of inversion in the yield of 10-year and 2-year US Treasury bonds has increased from -61BPs at the beginning of the year to -108BPs, with the narrowest range reaching -13BPs during the year and closing at -35BPs at the end of the year - which is basically in line with our expectations.
From the above comparison and retrospective analysis, although we were right in predicting the policy path of the Federal Reserve, we seriously misjudged the market's expectations for a soft landing of the US economy, to the extent that we significantly underestimated the peak yield of 10-year US Treasury bonds in this round of interest rate hikes. Therefore, when looking forward to the 2024 US bond market, we need to analyze the possible changes in market expectations.
Firstly, the confirmation of the Federal Reserve's current interest rate hike cycle is later than in the past. In the past, with the last rate hike by the Federal Reserve in the rate hike cycle, the market quickly confirmed the Fed's rate hike cycle (as the 1-year Treasury yield began to remain lower than the federal funds rate). However, due to the Fed's temporary halt to rate hikes in June 2022 and continued to release hawkish signals during this cycle, the market remained hesitant to confirm that the rate hike cycle had ended after the last rate hike in July 2023, In addition, the Federal Reserve emphasized "higher for longer" at its September 2023 meeting, further making the market feel that the Fed has not ended its interest rate hike cycle. Driven by this, the 10-year US Treasury yield not only broke through the peak of 4.34% on October 21, 2022, but also continued to rise above 5%, reaching above 5.02 on October 23, 2023.
The confirmation of the end of the interest rate hike cycle was not until November 2023, after the Federal Reserve's interest rate meeting, that the one-year US Treasury yield continued to be lower than the federal funds rate, indicating that the market began to price future interest rate cuts.
Secondly, the higher than expected increase in 10-year US Treasury yields is mainly due to the term premium. As mentioned earlier, the main reason why the actual trend of US bond yields in 2023 exceeded our expectations is that we expected the market to take nearly 4 months to confirm the end of this interest rate hike cycle, that is, the market situation from the end of July to mid November 2023 was not within our consideration range. During this period, the 10-year US bond yield rapidly rose from 4% to above 5%, The cumulative increase is nearly 100 BPs, but the driving force is entirely due to the implied term premium in the 10-year US Treasury yield (rising from -0.6% to 0.5%, with a cumulative increase of nearly 110 BPs).
The yield of 10-year US Treasury bonds mainly consists of two parts, namely risk neutral interest rate and term premium. Among them, the risk neutral interest rate is directly related to the policy interest rate, while the term premium is the compensation demanded by investors to bear the risk of possible changes in interest rates during the bond's validity period. In fact, it is the pricing that investors may face uncertainty in the future. The continuous increase of the term premium indicates that the market is increasingly concerned about the uncertainty it will face in the future. Since late November 2023, with the confirmation of the end of the interest rate hike cycle, the risk neutral interest rate and term premium have only begun to decline in parallel. In other words, the uncertainty that the market is concerned about has been partially relieved.
Data source: New York Federal Reserve
Thirdly, the US Treasury bond market has shifted from a unilateral trend to a two-way high volatility trend. Unlike the unilateral market trend in 2022, the bidirectional volatility of US bonds in 2023 is more pronounced. The Federal Reserve has cumulatively raised interest rates by 525BPs in this round, with 425BPs in 2022 and 100BPs in 2023. Compared with the three 75BPs, two 50BPs, and one 25BPs rate hikes in 2022, the Federal Reserve has returned to the rhythm of a single 25BPs rate hike in 2023. The switching of rate hikes has led to continuous changes in market expectations for the peak policy rate in this round, while inflation The fluctuation of employment data has also caused the market's economic expectations to fluctuate between a soft landing and a recession. Due to the fluctuation of market policy and economic expectations, the US bond market has shown a two-way high volatility trend.
Data source: Wind
Fourthly, the market's expectation of interest rate cuts has begun to be priced. After hitting above 5.02%, the 10-year US Treasury yield has started to price the expected interest rate cut. As of the end of 2023, it has dropped to 3.87%, which is equivalent to the level at the beginning of 2023. The corresponding maturity premium has once again fallen to a negative range of -0.44%. At present, the spread between the 10-year US Treasury yield and the federal funds rate is -150BPs, which is close to the bottom level of the spread between the two since the new century, reflecting that the market has begun to price the interest rate cut cycle.
Data source: Wind
Based on the above observations of market expectations and combined with the empirical patterns of changes in US bond yields and term premiums after the end of previous interest rate hike cycles, our current prediction of the US bond market in 2024 mainly includes the following four points:
Firstly, the market's expectations for the Federal Reserve's interest rate cut path in 2024 are relatively consistent (see the attached table below), but there is still significant uncertainty about whether the Federal Reserve can deliver on schedule. Our view is that only when there are clear signs of economic recession (such as a significant deterioration in the job market, detailed analysis can be found in "2024 Outlook: The Federal Reserve may surprise the market") will the Federal Reserve initiate interest rate cuts. If the Federal Reserve fails to cut interest rates as scheduled in March, market expectations will inevitably face another adjustment, and as a result, the high volatility of US Treasury bonds will continue.
Data source: Wind, where t represents the date of the last interest rate hike in a series of interest rate cycles.
Secondly, although the path of the Federal Reserve's interest rate cut is yet to be further confirmed, it is highly likely that the inversion of the US Treasury curve will be reversed under the expectation of interest rate cuts. The inverted yield of 10-year and 2-year US Treasury bonds will be completely reversed, and the degree of inversion between 10-year and 3-month US bond yields will improve. However, it cannot be completely reversed by 2024.
Thirdly, in terms of the 10-year trend of US bond yields, it is expected that the US bond yields will decline to around 3% in 2024. During this period, it is not ruled out that there will be a temporary return to the level of 4% or above due to changes in market expectations.
Fourthly, from historical data, it is not normal for the implied term premium of 10-year US Treasury yields to be in a negative range. It is expected that the term premium will return to a positive state in 2024, that is, the decline in 10-year US Treasury yields is mainly due to the decline in risk neutral interest rates, while the term premium is more likely to affect the volatility of US Treasury yields.
Of course, the US bond market is currently in a period of policy cycle switching, and any uncertain factors will affect the market situation. Therefore, we will continue to re evaluate the forecast at the beginning of the year as usual.
Data source: Federal Reserve, * is the expected rate cut path in the market.
Reference:
Outlook for 2024: The Federal Reserve may surprise the market
Economic Outlook for 2023 ④: 10-year US Treasury yields have crossed the hill
Re examination of the forecast for the yield trend of 10-year US Treasury bonds in 2023
The Conversion of Pricing Logic for US Bond Yield and Its Market Impact
After the interest rate meeting, what is the policy path of the Federal Reserve and the direction of US bond yields
Powell's policy path will once again shift from Volcker to Greenspan
US June inflation data may reveal three signals of changes in Federal Reserve policy