March 2018
Can Treasury Yields Continue to Rise
With 10-year US Treasury yields breaching 2.9% recently – its highest levels since 2014 – can yields go any higher?
- Rising growth expectations, higher energy prices and improving inflation measures have coincided with a significant pick-up in long duration supply as wider fiscal deficits in the US has led to an increase in Treasury issuance.
- At the same time, the Federal Reserve continues to shrink its balance sheet. The Fed has reduced its UST holdings by $18.7 billion since October 2017. Citi estimates that the Fed is expected to reduce their UST portfolio by $230 billion in 2018. With the private sector left to absorb an increasing amount of net supply, investors may demand higher yields.
- However – in Citi's view – a flatter US yield curve and a weaker US dollar could create a limit to UST yields.
"A flatter US yield curve and a weaker US dollar could create a limit to UST yields."
- Also, certain foreign exchange hedging costs are high at the moment – making hedging currency risk in some bond portfolios uneconomical. Thus, many international US bond investors must accept US currency risk when evaluating the merits of lending to the US.
- Even at low historic yield levels and structural problems with hedging currency risk, Citi analysts see the rise in long-term US bond yields remaining fairly limited in the year ahead – although Citi analysts still expect US high-yield bonds to outperform.
ECB Policies May Support EUR
Citi is still bearish on the USD for the medium term as the US government's recent spending bills and tax reform are likely to add pressure to the currency.
- Meanwhile, Citi analysts remain bullish on the EUR for the medium term. This view is driven by actual and expected changes in European Central Bank (ECB) policy. However, periphery politics triggered by the Italian Elections – for example – may pose a risk to the view. Also, the ECB may try to resist EUR appreciation in the short term.
- In Citi's forecasts, EUR/GBP could weaken in the near term but stabilize over the medium term – while longer-term projections (two years) forecast that it could return to above pre-referendum level. The biggest risk to this view remains any faltering in Brexit negotiations leading to pricing of a 'No Deal' scenario.
"EM currencies could be roughly flat over the next six to 12 months, although they might benefit from slightly cheap valuations."
- According to Citi, medium-term fundamentals are supportive of JPY. Japan's external balances are extremely robust, with the current account surplus reaching an all-time high in October 2017.
- Citi analysts think that emerging market (EM) currencies could be roughly flat over the next six to 12 months, although they might benefit from slightly cheap valuations. This forecast is mainly driven by stronger EUR and equities prices in this period.
- If the CNY continues to strengthen (as driven by USD weakness), more pressure may be exerted on China's trade competitiveness – though Citi analysts believe that the monetary authority may act upon its appreciation if it persists.
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