Core sovereign yields are heading North

Our baseline scenario for 2018 sees a moderate rise in benchmark bond yields. But US Treasury yields could be stuck at 2.5% as growth moderates and inflation remains stubbornly low.

In our start-of-the-year scenario for 2017, we thought that inflation, monetary and fiscal policy would push yields on core sovereign bonds higher, except on Japanese ones. In the event, political gridlock in Washington forced us to abandon our expectations for a significant fiscal stimulus in the US that would boost economic growth, while weakness in core PCE inflation means it is still well below the Fed’s target of 2%.

As a result, we have revised down our year-end target for the US Treasury yield to 2.5% from 2.8%-3% and for the 10-year. We have also revised down our year-end UK gilt yield forecast from 1.8% to 1.4%. By contrast, our start-of-the-year forecast remains unchanged for the 10-year Bund yield (0.7% by end-2017) and for the Japanese JGB yield (0%).

Looking forward to 2018, we anticipate that inflation, the business cycle and monetary policy will be the key macroeconomic factors for core sovereign yields. We see no strong catalyst for T-note yields to rise much beyond 2.5% by the end of next year. By contrast, we anticipate that the 10-year Bund and gilt yield will continue to rise, towards 1.0% and 1.7%, respectively. We also expect the Bank of Japan to raise its target on the 10-year JGB yield from 0% to 0.3%.

Growth in the euro area and Japan surprised to the upside in the first half of 2017, while growth in the US and the UK was mostly in line with economists’ forecasts. While we expect this uptrend to continue throughout the second half, we anticipate more moderate growth in 2018, especially in the US and in the UK.

According to our analysis, core inflation is set to accelerate by the end of next year in the US, in the euro area and in Japan. But we expect it to remain below central banks’ target of around 2%, except in the UK, where it should trend lower from the current level of 2.9%.

All in all, given our forecasts for a rebound in inflation, for moderate growth in all major economies and for a rise in base rates in the US and Europe in 2018, we continue to expect a rise in core sovereign yields, although this should be limited in the US.

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