Chief China Strategist
Summary: After hiking rates aggressively over the past 12 months, the Fed has caused the yield curve to be deeply inverted and banks to become less willing to lend. Following shifting to a risk-management modus operandi since November 2022, the building up of recession risks and stress in the financial system is likely to get the Fed to decide to end this rate hiking cycle. To benefit from this change in policy direction, investors may consider building long positions in short-term Treasury notes. Experienced traders, may express their views on the Fed’s policy path using the 3-month SOFR futures or 30-day Fed Fund futures contracts.
To catch the runaway inflation train which left the station in March 2021 when inflation decisively rose above the Fed’s 2% target and not looked back again, the Fed started raising the policy rate in March 2022. Chasing from behind after sitting on its hands for a year, the Fed raised rates by 475 basis points, taking the policy overnight Fed Fund target rate from a range of 0-0.25% to 4.75-5.0% in 12 months.
On November 25 last year, we published an article titled Bonds to shine in 2023 as the U.S. economy slows and the Fed moves into a risk management mode after the release of the FOMC’s November 1-2 minutes in which the Fed recognized explicitly the first time the importance of balancing of inflation risks and the cumulated impacts from prior rate hikes on the economy and financial stability. In that notes, we pointed out that the Fed had entered into a risk management modus operandi, and weighing between an increase and a pause would be in deliberation from meeting to meeting (Figure 1).
Now, we believe that the Fed has most probably reached the end of this rate hiking cycle as the risk of a credit contraction may eventually drag the economy into recession and pull the rate of inflation down cyclically despite the secular trend of inflation remaining elevated.
As Fed raised its overnight Fed Fund rate target, short-term interest rates soared to levels much higher than long-term rates and jeopardized the borrowing short and lending long business model. Even before the recent deposit flights from and stresses among some U.S. regional banks, banks have been tightening lending standards, in other words, less willing to lend, in the Fed’s Senior Lending Officer Opinion Survey on Bank Lending Practices in October last year and January this year (Figure 2). According to the latest Fed’s H-8 report, U.S. commercial banks’ outstanding commercial loans declined 5.9% in February from a year earlier.
With the deposit flights having happened over the past couple weeks, we anticipate that banks will continue to tighten lending standards and loans made to the corporate sector may contract further. The risks of a recession, credit distress, and financial instability have been increasing and may eventually, in a not too distant future, to tip the balance of the Fed’s policy decision into a pause or even cutting rates.
As the Fed is about to pause, Treasury yields tend to fall. The short-term Treasury yields are more directly a compounding of the expected Fed Fund rates in the coming months or coming one or two years. The yields on the longer-dated Treasuries, however, will tend to be driven by the expected path of trend economic growth, long-term inflation rate, and interest rate volatilities. Historically, when the Fed eases, short-term yields tend to fall faster and more than longer-term yields (Figure 3).
Before a recession, the yield curve is often inverted to reflect that the monetary policy is too restrictive and is about to trigger a slowdown in economic activities and inflation, leading to subsequent rate cuts. When approaching a recession, the market start pricing in the upcoming rate cuts and causes yields to fall but more so in short-term yields as the longer-term yields start to price in a recovery some years later. As a result, the yield curve steepens (Figure 3).
As the yield curve currently is still inverted and at the early stage of approaching a Fed pause, the steepening in the yield curve may have more to go and eventually turn from sloping downward to sloping upward, i.e. short-term yields lower than longer-term yields. Short-term Treasuries may have room to fall much further in yields (Figure 4) and appreciate in prices.
For investors looking for diversification and an income stream, short-term Treasuries are a good place to start from. Click here for a concise introduction to why and how to add bonds to your portfolio.
Historically, when banks are tightening lending standards and the economy is approaching but not yet in a recession, credit spreads, that are the additional yields provided by corporate on top of the Treasury yield of similar maturity, tend to widen. Credit spread widening has a negative impact on the price of the corporate bond. Therefore, it is advisable to be in Treasuries before a recession and then switch the Treasuries that investors have into corporate bonds when the economy is deep into recession and the Fed is injecting massive liquidity trying to drag the economy back into its feet. Now is probably too early and the additional yields that investors get from taking additional credit risks are too low (Figure 5).
The Saxo trading platform can help investors to find the bond that suit their investment objectives and their views about the market. For example, to find Treasury notes up to five years in maturity, investors can select bonds for “instrument”, government for “issuer types” and up to 5 years for “maturity year”, and USA for “countries” (Figure 6).
The mid-yield column gives you an idea of the annual investment return that investors can expect if they buy and hold the Treasury note to maturity. For example, the 2-year Treasury note with a 4.625% coupon, maturing on February 28, 2025 has an indicative yield at 3.74%.
U.S. Treasuries pay coupons semi-annually. For example, for a 4.625% coupon, investors will get pay 2.3125% of the par value (100) every six months. The market convention for quote prices in Treasuries is at the 32nd. For example the price “101 18/32” on the screen represents 101 and 18/32 which is 101.5625 in decimal points.
For investors who prefer the simplicity and convenience of ETFs to doing the security selection themselves, iShares 1-3 Year Treasury Bond ETF (SHY:xnas) is an option to consider.
For traders who prefer utilizing leverage to get exposure to the short-term Treasures, they may consider taking a long position in the June 2023 Two-year US Treasury note futures contract (ZTM3). The contract settles by physical delivery and tends to track the yield of the cheapest-to-delivery Treasury note which has a remaining maturity between one year and nine months and two years. Traders who are well versed in option trading can also choose to express their views using options on the ZTM3 contract.
Traders who have a view on the Fed’s future rate path and want to put their views into a trade can consider the SOFR futures contracts. The 3-month SOFR futures are priced as 100 minus the compounded secured overnight financing rate (overnight repo rate) per annum during the contract reference quarter. For example, the September 2023 3-month SOFR futures (SR3U3) is trading at 95.985, which implies a 3-month interest rate of 4.015% p.a. (100 – 95.985 = 4.015) for the 3-month period (reference quarter) from September 20 to December 19, 2023.
Traders who expect the Fed to cut rate aggressively in 2023 as the contraction in credit is causing the U.S. economy slipping into recession and inflation to fall, they can buy the September 2023 3-month SOFR futures contract at 95.985 in expectation of the contract price to go up as the 3-month interest rate to fall much below the current implied 4.015% for the period from September 20 to December 19, 2023.
On the other hand, traders who think the Fed will fixate its eyes on elevated inflation and will not cut interest rates in 2023 can express their views by selling the September 2023 SOFR contracts at 95.985, expecting the 3-month interest rate to rise from the implied 4.015% level for the move towards the current target range of 4.75%-5.0%.
The last trading date for the SR3US will be December 19, 2023 and the valuation date for cash-settlement will be on December 20, 2023, the third Wednesday of the delivery month (December in the case of the 3-month September contract).
The 3-moth SOFR contracts are highly liquid and are the preferred instrument for professional money market traders to trade and hedge interest rate risks. Alternatively, for investors who prefer the most direct exposure to the Fed Fund rate, they can also consider the Fed Fund contract which is quoted similarly to SOFR contracts but it tracks the 30-day arithmetic average of the daily overnight effective Fed Fund rate over the delivery month. For example, the settlement price for the Dec 2023 30-day Fed Fund futures contract (ZQZ3) is 100 minus the 30-day arithmetic average of the effective overnight Fed Fund rate from December 1 to 29, 2023 for cash settlement on January 2, 2024.
As the market is volatile and swinging widely day by day, it is also good to remember that Saxo is paying competitive interest rates for clients’ cash deposits as they are waiting for their desired level of yields to start accumulating short-term bonds.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
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With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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