Head of Fixed Income Strategy
1. Hawkish scenario. The dot plot indicates two rate cuts, coupled with higher growth and inflation expectations for 2024, reflected in changes to the Summary of Economic Projections (SEP). Consequently, the yield curve is likely to bear-flatten. Two-year yields might test and break above their 200-day simple moving average at 4.75%, finding resistance at 4.95%. Similarly, ten-year yields may break above 4.35%, encountering resistance around 4.5%.
2. Base case. Although the dot plot displays dispersion, it doesn't eliminate the possibility of more than two rate cuts. However, changes in the SEP show better growth expectations while inflation aligns with previous forecasts. In this scenario, the US yield curve may bear-steepen as the front part remains rangebound, while long-term yields would soar on the back of a stronger economy than forecasted previously.
3. Dovish scenario. The dot plot maintains expectations of three rate cuts, accompanied by a deterioration in the growth outlook reflected in changes to the SEP. The yield curve is likely to steepen. Two-year yields might test their 50-day simple moving average at 4.47%, which, if they break, would find resistance at 4.4%. It's unclear whether 10-year yields will follow. If concerns arise in the bond markets that a dovish Federal Reserve may trigger another wave of inflation, a yield curve twist could occur. It would involve the front part of the yield curve shifting lower while the long end moves higher, possibly pushing 10-year yields toward 4.5%.
While the bond market is still optimistic about a soft landing, it anticipates that inflation may persist above the Federal Reserve's 2% target for an extended period. This sentiment is underscored by the 10-year breakeven rate, which has risen to 2.31% from its December low of 2.16%.
Further contributing to concerns about potentially persistent inflation is the February survey by the New York Fed. The survey indicates that while 1-year inflation expectations have bottomed out around 3%, expectations for 3-year and 5-year inflation have rebounded from their January lows to 2.7% and 2.9%, respectively.
Consequently, bond futures markets are beginning to question the likelihood of the Federal Reserve delivering the three rate cuts projected in December's Dot Plot. SOFR futures, for instance, are pricing 72 basis points of rate cuts in 2024, with a 50% probability of the first rate cut occurring as early as June.
In December, the SEP painted a picture of a slowing US economy, anticipating GDP moderating to 1.4% by the end of 2024, unemployment rising to 4.2%, and core inflation falling to 2.4%. Yet, since the beginning of the year, the economy has continued to grow above trend, unemployment remains comfortably below 4%, and inflation is showing signs of stabilizing around 3%.
Given these developments, it is likely that the SEP will undergo revisions to reflect this economic resilience, though expectations for 2025-26 may remain unchanged. Notably, the December SEP suggested that core inflation wouldn't reach the Fed's 2% target until 2026, which constrained the central bank's ability to foresee more than three rate cuts for the year.
Market observers will closely scrutinize any alterations to the dot plot and inflation expectations. The bond markets' stability hinges on the Federal Reserve's effectiveness in steering inflation towards its 2% target. If the median dot plot indicates fewer than 75 basis points in rate cuts this year, it may signal lingering concerns among policymakers regarding a rebound in inflation.
It's crucial to highlight that current market sentiment is notably more optimistic about the economy than the Fed is. Consensus estimates expect US GDP to end the year at 2.1% and unemployment to stand at 4%. As long as the economy continues to outperform the Fed's expectations, policymakers are unlikely to accommodate it with interest rate cuts.
While liquidity in financial markets remains abundant, policymakers are growing concerned that ample reserves may soon be depleted, potentially leading to a liquidity event similar to the one witnessed in September 2019. According to a paper published by the St. Louis Federal Reserve, ample reserves should ideally range between 10% and 12% of the country's GDP, equivalent to approximately $2.9 to $3.3 trillion.
With bank reserves at the Fed around $3.5 trillion and the Reverse Repurchase Facility (RRP) slightly below $500 billion, reserves in the system are obviously ample. However, according to consensus estimates, the RRP facility is expected to approach zero around summertime. At the same time, quantitative tightening (QT) will accelerate runoffs of T-Bills on the Fed balance sheet because coupon redemptions will not hit the $60 billion QT cap every month. Roughly $170 billion of T-bills are projected to run off the Fed's balance sheet within a year if QT is not tapered, accelerating the pace at which the level of ample/scarce reserves will be hit.
It is evident that if the Fed aims to manage the reduction of reserves gradually, adjustments to QT will be necessary sooner rather than later. A decision on this matter could be reached as early as this week's meeting or at the latest, by June. However, the outcome may not align with the expectations of bond markets. We expect the Fed to continue to run off coupon maturities and reinvest redemptions exceeding the monthly Fed cap into T-bills rather than being proportionally distributed across US Treasury auctions. Click here for more details on this topic.
Recent hot inflation data has prompted investors to question whether inflation is truly under control. Both CPI and PPI indicators show signs of stabilizing around 3%.
There's the risk that if the SEP economic projections and dot plot suggest the Federal Reserve is overly eager to implement rate cuts, bond vigilantes could emerge. Bond vigilantes are simply bond investors demanding a higher term premium as the risk of a potential second wave of inflation looms.
The term premium surged to 40 basis points in November and turned negative in December. However, if the Fed appears too complacent about inflation, the term premium may revert to positive territory, exerting pressure on the longer end of the yield curve.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.
2024: The wasted year
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.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
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.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
