The 10-year Treasury yield will drop to 3.5% by the end of next year as the massive bond rally will continue, UBS says

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The 10-year Treasury yield will drop to 3.5% by the end of next year as the massive bond rally will continue, UBS says
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  • The 10-year Treasury yield should drop to 3.5% by the end of 2024, UBS said.
  • That's down from about 4.3% now as the Fed will likely cut rates two to three times next year.
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The bond rally should continue into 2024, as debt markets get a boost from dovish Federal Reserve monetary policy, UBS said in a Friday note.

The 10-year Treasury yield should drop to 3.5% by the end of next year, down from about 4.3% now, as the Fed implements two to three interest rate cuts.

Already, market expectations of a central bank pivot have bolstered Treasury prices, partially reversing a massive sell-off that began in 2020 and ran to October. In fact, November marked US fixed-income's best performing month since 1985, with global bonds enjoying their best month since 2008.

"But despite this strong run, our view is that bonds can rally further next year," UBS said.

It's likely that the Fed has reached the end of its hiking cycle, given the recent cooldown in inflation and the labor market's easing, UBS said. A drop in excess savings next year should continue bearing down on inflation, allowing the Fed to lower rates.

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While markets are pricing in odds that Fed rate cuts could start as soon as March, UBS predicted they're likely to start in July. Additionally, the decline in yields might not happen steadily, especially as Fed officials have recently sent mixed signals about how monetary policy will unwind.

For instance, while some officials have touted dovish outlooks, New York Fed President John Williams noted on Thursday that rates could remain restrictive for a longer while, sending the 10-year yield higher.

Meanwhile, other bond market concerns could also make a comeback, such as worries about the flood of new Treasurys being issued.

Increased debt supply this year caused the term premium — or the added compensation investors expect for holding an asset — to jump as buyers balked at ballooning federal deficits. Recent months have seen also demand for Treasurys take a hit in some auctions.

"The biggest risk for the market is a failed bond auction, where the Treasury receives fewer bids than the face value of securities it wishes to sell," UBS warned.

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But that's unlikely, it added, saying future debt supply concerns should be manageable. That's as bank reserves have held steady, despite earlier warnings that the Fed's ongoing balance sheet reductions would drain their cash. This allows dealers to continue acting as buyers in weak auctions.

Meanwhile, UBS also expects the Fed would intervene in the bond market to restore stability, if necessary.

"So, we continue to recommend high-quality (specifically high grade/government and investment grade) bonds with a 1–10-year duration, particularly the five-year segment," the note said.

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