Longer-term bond yields are expected to increase further

Steven Barrow, Head of Standard Bank G10 Strategy ccontinues to believe that 10-year Treasury yields will climb to 5%, or more, in coming months as the US economy remains sprightly, inflation sticky, and fiscal largesse a worry. This despite the fact that we still expect the Federal Reserve to trim policy rates. The last rate cut from the Fed in December came in spite of the fact that FOMC members lifted their forecasts for inflation to 2.5% this year for PCE prices, as opposed to the 2.1% median forecast of FOMC members in the previous Summary of Economic Projections (SEP).

We believe that the Fed’s insistence on delivering more policy easing was partly driven by concerns that the labour market could lose too much steam. The Fed is pretty unique in having a dual inflation and employment mandate, and, with inflation close to target, members have made it clear that inflation and employment have broadly equal billing in the Fed’s reaction function, as opposed to the dominance of the inflation objective when price growth was far above target.

Right now, the unemployment rate is in line with the Fed’s full employment mandate, but members appear concerned that the unemployment rate could start to rise more rapidly. However, the unemployment rate in the United States went down to 4.1% in December of 2024 from 4.2% in the previous month, below market expectations of 4.2%.

Hence, it seems likely to us that Fed members would not like to see the average monthly employment gain slip too far below this level. Indeed, Fed Governor Kugler hinted as much in comments at the weekend. An added problem for the Fed is that workforce growth has just become less predictable given the deportation and border threats from incoming President Trump.

Should his policies contract the available workforce, the unemployment rate will likely start to fall again and so challenge the Fed’s ability to cut policy rates significantly. But it is not just migration that’s of concern to the bond market, as budget policy and tariff policy also stand out as sources of potential inflation and hence potentially higher bond yields. “We feel that these risks imply a 10-year yield of 5%, or more, even if we do see this as a temporary peak and not a sign of significant medium-term deterioration in the Treasury market," said Steven Barrow.

In theory, at least, most other central banks have an easier time than the Fed, as they only have one objective, inflation, not two. But, in practice, Steven Barrow doubted that any central banker thinks he or she has an easy task. Take the Bank of England. It has started to deliver policy easing, but in a very cautious way. Its task is not being helped by the fact that the October budget imposed a higher tax burden on businesses. Since the budget surveys have suggested that these tax hikes could create weaker growth but also higher inflation,.

For instance, a smaller-firm survey by the British Chamber of Commerce (BCC) found that sales expectations have fallen to the lows seen during the disastrous Liz Truss government in September/October 2022. But rather than see this demand pressure as a spur to lower prices, the increased labour costs implied by the October tax hike seems to be pushing over half of firms (55%) to project price increases, as opposed to the 39% that we saw before the budget.

In all, it seems to leave the Bank of England in a stagflationary quagmire, and the conclusion by members might be that policy has to be left on hold until the implications of the tax changes become clearer. An added problem, which we are also seeing for the ECB as well, is that European energy prices have risen notably; something that will also add to inflationary pressure. With all this in mind, it might seem as if the BoE will remain cautious compared to other central banks.

However, Steven Barrow’s view is that price pressure will melt away and the Bank will be faced with a need to reduce rates more quickly. Hence he sees base rates falling by up to 150-bps over the coming year compared to market pricing of little more than 50-bps.