US 10-year should settle in the 3% to 3.5% range? - ING

According to Padhraic Garvey, Global Head of Debt and Rates Strategy at ING, one argument for 10-year yields not breaking above 3% is the likelihood that the US economy could slow, let’s say starting in 2020 as prior rises in the Fed funds rate begin to bite. 

Key Quotes

“This could occur against a backdrop where the fiscal deficit could be threatening a 5% handle as tax reform hits government revenues. And this added to a growing shortage of savings in the private sector could coincide with the deficit on the balance of payments heading towards a similar big figure. Therein lies the genesis of an imbalance that could well pre-empt a growth recession, likely necessitating eventual mild Fed cuts say from 2021.”

“Related to the long term, another item to consider is the long bond (30yr) yield. In days gone by this was the benchmark of the US yield curve, and still garners respect as a back-end anchor for the US curve. The point here is the long bond yield currently sits at 3.15%. By virtue of its tenor, the long bond yield has an ultra-long nose and is suggesting that US rates should not be getting much above 3%. We’d be having a very clear conversation on the logic of the 10yr breaking above 3% if the long bond yield was at 4% for example. Not as straight-forward where it currently is; accepted.”

“The counter-argument, however, is that fundamentals are just too bubbly to be ignored, plus the wage inflation/core inflation upside trajectory looks increasingly persuasive. That’s where our judgment lands. We are not convinced that the bond market sell-off is over. The long bond yield conundrum is more likely to be squared with the 10/30yr segment inverting at some point later in 2018. An inversion on the 2/10yr segment is less likely in 2018, reflecting a minimal imminent recession risk.”

“Market positioning is also an important input when it comes to timing and extent of the move. Around the turn of the year the flows data that we track show investors selling long end funds and buying short end funds, in order words they were shortening the duration and positioning for higher rates. That has calmed since, which in part explains why a subsequent break higher in the 10yr yield has not occurred, yet.”

“We expect this to change, likely to be bullied there by persistently firm fundamentals in the coming quarters. Chicken and egg kind of a situation, but all converging on a likely break above 3%.”

“There is no firm evidence that the 10yr yield should break higher than 3.5%. We find that a material rise in core inflation to 2.5% would be required to make this happen. So not improbable, but not our base view. Hence the notion that the 10yr rate should settle somewhere between 3% to 3.5%. Our point estimate is 3.4%, which also helps project the prognosis that any break above 3% would be sustained for at least a few quarters.”

“To get above 3% in the first place, there needs to be a market discount where imminent inflation risks trump medium-term growth recession risks. And by the way, we see the Fed funds rate heading towards a terminal value towards 3% on similar reasoning. The end game, in fact, sees the curve flattening out completely with the three handle heavily in play.”

“Having marked these, subsequent rates moves would indeed then be lower.”