Bond Market Anticipates Divergence from Fed, Forecasts Sharp Decline in U.S. Yields

Bullion Bite

Divergence in the bond market from the Federal Reserve's stance has become entrenched, as indicated by U.S. yield forecasts. According to a recent Reuters poll of strategists, the bond markets have already factored in interest rate hikes that are expected to occur in the coming months, with short-dated yields projected to decrease significantly. Most strategists believe that the year's highs will not be revisited.

After reaching a peak of 5.08% on March 8, triggered by hawkish testimony from Fed Chair Jerome Powell, 2-year yields have consistently traded below that level. The decline was further accelerated by concerns surrounding smaller U.S. banks following a rescue operation conducted by the Fed for Silicon Valley Bank, leading to a safe-haven plunge.

Despite the economy and banking system demonstrating resilience, as well as the latest projections from Fed policymakers suggesting the need for two additional quarter-point rate increases, the bond markets have remained detached from these factors. The market's near-term trajectory will largely depend on Powell's forthcoming testimony to Congress, particularly if he reaffirms the rate hike outlook. A confirmation of this view may result in a surge in yields and subsequent upward revisions to forecasts in the weeks ahead.

Interest rate futures are currently indicating the likelihood of only one more rise. Median forecasts from the poll of 26 strategists conducted between June 15 and 21 suggest that the yield on the 2-year Treasury note, which is traditionally sensitive to the near-term monetary policy outlook, is expected to decrease by approximately 70 basis points in the next six months, reaching 4.00% from its current level of around 4.70%. Although this projection remains significantly below the 16-year high witnessed in March, subsequent to Powell's previous Congressional testimony, it still stands above the low of 3.55% recorded on March 24.

Bas Van Geffen, a strategist at Rabobank, noted, "That is essentially the markets getting ahead of the anticipated tightening. It is going to be very difficult for the Fed to convince markets they will keep rates higher... and that there won't be a quick pivot."

When asked an additional question, 15 out of 20 strategists responded that the 2-year Treasury yield was unlikely to reach its cycle peak within the next three months. Only two out of 27 respondents predicted that the 2-year yield would trade higher than its current level by the end of August, with the highest forecast at 5.00%.

The forecast for the benchmark 10-year note yield indicated a smaller decline of approximately 25 basis points over the next six months.

While the 2- to 10-year yield spread is expected to remain inverted, the poll revealed that it is projected to narrow by about 50 basis points from its current level of nearly 100 basis points.

Although an inverted yield curve historically suggests an impending recession, the economy has defied expectations as it has remained inverted for almost a year without such an outcome. Robert Tipp, the chief investment strategist at PGIM Fixed Income, explained, "The economy has been more durable, and inflation higher for longer than market expectations... Persistence of this configuration — continued growth along with above target inflation — will keep mild upward pressure on two-year and 10-year yields."

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