Capital Economics: Bond sell-off will continue – From 2023-2024 spreads and yields will decline

Her Eleftherias Kourtali

Government bond yields will peak earlier and, in some cases, higher than previously expected by Capital Economics as international monetary policy cycles tighten and become more aggressive.

In April, Capital Economics noted that long-term bond yields in developed markets would rise further as central banks tightened their monetary stance. He had also estimated that these yields would peak around mid-2023, when the tightening cycles of most central banks would close.

Part of this assessment has proven to be correct, he points out. Indeed, 10-year bond yields have risen sharply in recent months. This appears to have mainly reflected reflections in policy interest rate expectations in the short term, as central banks accelerate policy normalization.

“However, the speed of the sell-off in the bond markets surprised us,” the house points out. Although yields remain generally below the levels it expected to peak, they are above its targets for the end of 2022. Meanwhile, it is now valuing increasingly aggressive interest rate hikes by central banks.

Capital Economics points out five important points regarding bond markets from now on, based on recent developments.

First, it believes that bond sales will continue for the rest of this year. Data from previous US tightening cycles suggest long-term yields tend to peak near the latest rate hike and expect central banks to generally continue to raise interest rates over the next six months.

Second, it expects 10-year bond yields to peak around the end of this year, rather than mid-2023. This reflects the fact that it now expects that tightening in most developed markets will end in early 2023 or even late 2022. On the contrary, he previously expected that the tightening cycles would end in mid-2023.

Third, in some areas, it also expects bond yields to peak, reflecting its expectation that interest rates will rise more than previously thought. For example, it now predicts that the yields on 10-year US bonds and 10-year German bonds will peak at 4% and 2.25%, respectively (from 3.75% and 1.75% before).

Fourth, yields will decline in 2023 and 2024 as investors begin to expect monetary easing. The initial reductions in yields will be relatively modest in the US, the UK and the eurozone, as relaxation cycles will not start until 2024 at the earliest. In contrast, more significant reductions in yields are expected in Canada, Australia and New Zealand as central banks begin easing policy earlier.

Fifth, the eurozone spreads will widen further this year, before declining in 2023 and 2024. However, in the last week they have declined as the ECB seemed more willing to intervene to avoid “fragmentation”. However, Capital Economics believes that the prospect of monetary tightening of the ECB and the deterioration of the appetite for risk assets in general will put significant upward pressure on the spreads of the region this year. In this context, a fairly unlimited commitment of the ECB to buy bonds of the South would be enough to prevent a new rise in spreads. The CE believes that it will eventually make such a commitment, but it will take some time and more pain in the regional bond markets to do so.