Although it's challenging to forecast the economic outlook due to the evolving situation in Ukraine, it’s fair to assume that the Fed will stick to its hiking plan to fight inflation. Suppose the central bank is concerned about a slowdown in growth. In that case, it will look to front-load interest rate hikes this year as the economy remains strong and the choice to fight inflation remains popular. Therefore, it’s safe to expect the yield curve to continue to bear-flatten.
Since last week, two-year US Treasury yields have been testing strong resistance at 2%, a level previously seen in May 2019, when the Fed fund rate was 2.5%. The Fed is looking to bring the benchmark rate at 2% by the end of the year and 2.75% in 2023. Suppose markets deem this hiking path to be realistic. In that case, there is definitively room for 2-year US Treasury yields to begin to price rate hikes for 2023 throughout the year. Yet, rate hikes for this year have already largely been priced in the front part of the yield curve. Therefore, two scenarios are possible: either growth remains sustained throughout the year, giving the green light to the Fed to hike rates as planned, or growth will get seriously hit in the second half of the year, forcing the market to reconsider rate hikes for 2023. We would probably see 2-year yields moving towards 2.5% in the first scenario. In the second scenario, the front part of the yield curve would remain around the values we see today.
We believe that there is a bigger chance of seeing 2-year yields breaking above 2% in the short term and remaining sustained above this level until summer as the central bank's language has become hawkish. However, as the macroeconomic outlook becomes clearer, there are chances that the market begins fearing a recession. In that case, 2-year yields would remain around the levels we are currently seeing.
Similarly, we don't believe that long-term yields will plummet unless there are clear signs of stagnation, which might not surface until the year's second half.