While the market is betting on the Federal Reserve skipping a rate hike in June, HSBC has confirmed that long-term U.S. bond yields have already peaked.
Earlier this week, HSBC's Global Fixed Income Research Director, Steven Majo, and U.S. Rate Strategy Director, Lawrence Dye, jointly released a research report. It stated that U.S. bond yields peaked last October, with 10-year and 30-year U.S. bond yields reaching 4.24% and 4.38% respectively. HSBC's chart showed that the 10-year and 30-year U.S. bond yields have been steadily falling since October.
HSBC's report indicated that the global fixed income market was in the midst of a "perfect storm," still dealing with shocks from the UK bond market and soaring U.S. inflation, as investors anticipated China's reopening would boost the economy.
According to HSBC, the global bond market was experiencing turbulence at the time. A budget proposal by former UK Prime Minister Theresa May sparked a storm in the bond market. By the end of October, 10-year UK bond yields had surged about 150 basis points since mid-September. In the U.S., the Federal Reserve was in its most aggressive tightening cycle in over four decades, with successive substantial rate hikes of 75 basis points.
HSBC expressed its admiration for the resilience of long-term U.S. bonds, considering that the Federal Reserve had already hiked rates five times since the yield peaked on October 24, 2022. The Fed hiked rates by 75 basis points in November, 50 basis points in December, and 25 basis points the following three times. In five months, the Federal Reserve has raised rates by 200 basis points, while the yield on 10-year U.S. bonds is still 50 basis points lower.
HSBC believes that the peak in yields is actually a reversal of fundamentals. The bank found that long-term yields often face constraints from the long-term trend of GDP, such as actual yields often being lower than GDP growth.
HSBC noted that since this round of rate hikes began, the Federal Reserve has raised rates by 500 basis points, and further rate hikes could potentially push the U.S. into a recession. That is, if a recession occurs, the next significant policy move is more likely to be a rate cut, which would mean that real yields could continue to fall.
This also explains the significant inversion between the federal funds rate and the yield on two-year U.S. bonds, as well as the inversion between the yields on two-year and ten-year U.S. bonds.
Observing the performance of the yield curve during previous rate hike cycles, HSBC found that when investors anticipate the next major move in policy rates to be a rate cut, the spread between two-year federal funds usually enters a balance reversal. As the Federal Reserve begins to relax policy, the inversion often intensifies.
Once the funds rate reaches a loose level, this part of the yield curve may tilt upward. Given the Federal Reserve's expectation of a neutral interest rate of 2.5%, as long as the interest rate is below this number, the yield curve will exhibit a positive slope.
HSBC discovered that the long end of the curve moves in advance, and observed that 10/30 year U.S. bonds normalized before the yield on 2/10 year U.S. bonds. The 2/10 year U.S. bond inversion also established a balanced level, which is often more stable when the Federal Reserve is in easing mode.
When the rate hike cycle turns, both the two-year and ten-year U.S. bond yields may drop significantly relative to their initial levels.
However, when it is expected that the funds rate will not rise to a very loose level, the level of the yield on ten-year U.S. bonds may be stickier, which is what current general predictions imply.
The Federal Reserve may skip June and raise rates at the July meeting, a move that has largely been priced in by the market. HSBC pointed out that anyway, the Federal Reserve will cut rates in 2024, and stay in line with its dot plot.
But if the forward curve has already digested this expectation, how can future yields fall?
HSBC noted that current yields reflect investors' hedging sentiment. The U.S. bond due to mature on December 15, 2025 (with a face interest rate of 4%) - the representative of the two-year benchmark U.S. bond at the end of the year, currently yields 4.25%, 100 basis points higher than the upper limit of the federal funds rate.
In the absence of Federal Reserve policy easing, U.S. bond yields are expected to rise about 20 basis points, but in the case of easing, yields may drop at least 50 basis points, depending on the extent and speed of rate cuts.
HSBC believes that if the U.S. economy achieves a soft landing, the Federal Reserve may raise rates by 25 basis points in July, but a hard landing scenario might require significant rate cuts.
As of the close on Friday, the yield on ten-year U.S. bonds rose slightly to 3.745%. In contrast, the median predictions for the end of 2023 by Forward and Bloomberg were 3.64% and 3.37% respectively, about 100 basis points higher than HSBC's forecast.
