US yields to trend higher on a 6 to 12-month horizon – Danske Bank

Chief Analyst, Arne Lohmann Rasmussen at Danske Bank, suggests that currently, the Fed seems caught between a strong rebound in private consumption and recent job reports indicating a significant slowdown.

Key Quotes

“These mixed signals put the Fed in a difficult position, which explains why it chose a ‘wait and see’ approach at the latest FOMC meeting. The Fed ‘dots’ signalled two hikes this year (unchanged) and three hikes next year (revised down from four). That said, most individual ‘dots’ were lowered and since we believe most voting FOMC members have a dovish-to-neutral stance on monetary policy, the ‘true’ signal from the ‘dots’ for this year is most likely a signal of one hike, not two. In this connection note that the average ‘dot’ for this year was lowered below two hikes while it was above two in the last projection.

Although GDP growth disappointed in Q1 and recent job reports have been weak, we do not think the US is slowing significantly and private consumption and less headwind should keep the engine running. We still think it is likely that the Fed will hike in September but stress that risks are skewed towards a later hike.

The UK’s EU vote means that our Fed call is surrounded by even more uncertainty than usual as a ‘Brexit’ is a potential game changer for the Fed. A ‘Brexit’ would postpone the second hike even further as it would likely result in slower global growth which the US is not immune to. Based on our main scenario we still expect three hikes next year.

In recent weeks US yields have moved down and currently markets price in only a 50/50 probability of a hike this year and just one hike in total before year-end 2017. We could see a re-pricing of Fed expectations if no ‘Brexit’ is seen. However, the global ‘hunt for yield’ intensified by record-low German and Japanese yields means that we still have a positive environment for global fixed income markets. US treasuries are the only major market that offer a 10Y yield above 1.5%.

Hence, on a 12-month horizon we expect to see a further flattening of the curve 2Y10Y as more Fed hikes are priced in and as investors ‘hunt’ the higher 10Y US yields. Hence, there will be little scope for higher 10Y yields. Eventually the Fed will, however, resume its hiking cycle, causing US yields to trend higher. The move higher in US yields is mainly expected on a 6 to 12-month horizon.”