"U.S. Treasury Yields to Peak in Q4, Then Fall...10-Year Yield Forecast to Top Out at 5.5%" [Weekend Money]

Peak expected between the October and December FOMC meetings
Rising yields driven by resilient growth, inflation, and Treasury issuance
"Much of the news is already priced in"... Risk-neutral yield could fall 20 bp

There are forecasts that the yield on the U.S. 10-year Treasury, a global benchmark, will climb to around 5.5% and peak in the fourth quarter. A resilient U.S. economy, inflation, and growing Treasury supply are putting upward pressure on yields. However, analysts say these factors have already been largely priced in, making it likely that yields will fall after peaking in the fourth quarter.

File photo. Photo by The Asia Business Daily DB.

In a recent bond strategy report, LS Securities forecast that the 10-year U.S. Treasury yield is likely to peak sometime after the October Federal Open Market Committee (FOMC) meeting and before the December FOMC meeting. It put the upper end of the 10-year yield range at 5.38%, and at 5.52% if the largest increase seen in past cases is applied.

The first reason for the recent rise in U.S. long-term yields is that economic growth and inflation have been stronger than expected. According to GDP nowcasts, estimates of U.S. growth from the first through third quarters have been gradually revised upward, while personal consumption and fixed investment are supporting economic growth. Inflation is also rising again as international oil prices rebound. Woo Haeyoung, an LS Securities researcher who wrote the report, said, "Core inflation has also failed to cool quickly," adding that it "remains sticky and above the target."

Market expectations for the U.S. Federal Reserve's (Fed) monetary policy path are also pushing yields higher. The outlook is considered more hawkish (favoring tighter monetary policy) than the September dot plot, which signaled one additional rate hike this year. "The market expects faster and more rate hikes," Woo said. The explanation is that, because the Fed has previously been slow to respond after judging inflation to be temporary, the market is calling for further preemptive action.

The U.S. government's fiscal deficit and increased Treasury issuance have also been cited as factors driving up long-term yields. The fiscal deficit, which expanded after the COVID-19 pandemic, has not returned to its previous level, and Treasury issuance to cover the deficit continues. Woo said, "Interest payments are bound to keep increasing," adding that "another source of concern is that investors in U.S. Treasuries, both domestic and foreign, have shifted from the public sector to the private sector."

Another concern is that hyperscalers making large investments in artificial intelligence (AI) are issuing more corporate bonds, absorbing some of the funds that would otherwise flow into U.S. Treasuries. Some investment banks (IBs) estimate that increased AI-related borrowing has raised U.S. Treasury yields by about 30 bp this year (1 bp = 0.01 percentage point).

Other factors cited as putting upward pressure on yields include rising inflation and policy rate hikes in major economies, which have jointly intensified upward pressure on short- and long-term yields in global bond markets, as well as simultaneous increases in the risk-neutral yield and the term premium.

However, LS Securities does not expect U.S. Treasury yields to keep rising. It considers the risk-neutral yield to be the key component of long-term yields that will determine their future direction. This is because many factors that could push up the term premium, including rising international oil prices and inflation, fiscal deficits, and increased Treasury supply, have already been largely priced into the market. Woo said, "Factors pushing up the term premium are fueling market unease, but they are already known. Unless conditions worsen far more than expected, a further sharp rise in the long-term term premium is unlikely."

Past yield trends also support the forecast of a fourth-quarter peak. In the report, LS Securities analyzed four periods when the levels of U.S. 2-year and 10-year Treasury yields were similar to current levels: 1993-1995, 1996-1998, 1998-2001, and 2006-2007. In these cases, the long-term risk-neutral yield either began to fall before or around the time of the final rate hike, and the long-term term premium also declined after the final hike.

Woo said, "According to the latest data, as of October 2, the 10-year risk-neutral yield was 4.34% and the term premium was 0.913%." He added, "If the outlook gradually becomes more likely to follow the September dot plot , the risk-neutral yield will fall preemptively by around 20 bp before the December FOMC meeting."

Under the September dot plot, the December FOMC rate hike is expected to be the last one, which raises the possibility that the risk-neutral yield will fall beforehand. Accordingly, LS Securities expects downward pressure on yields to gradually build if the Fed holds rates steady at the October FOMC meeting and the subsequent path proves close to the September dot plot.

Woo said, "The term premium is generally likely to decline after the final rate hike is confirmed. Based on past cases, it could rise by a further 18-45 bp before the final hike, with an average increase of 31.3 bp." He added, "We believe the 10-year yield is likely to peak after the October FOMC meeting and before the December FOMC meeting, with the upper end of the range at 5.38% using the average and 5.52% using the maximum."

This content was produced with the assistance of AI translation services.