Head of Fixed Income Strategy
Summary: The long part of the US yield curve looks out of grasp. The market might be underestimating the Federal Reserve's concern for inflation and the upcoming tightening cycle. The probability for long-term yields to rise and the yield curve to steepen on the back of today's FOMC meeting is high. Yet, we don't expect 10-year US Treasury yields to break above the range they have been trading in throughout this year due to current yield-compressing factors.
Ahead of tonight’s FOMC, we would like to highlight the importance of interest rates expectations when considering possible yield curve moves. To do that, it's key to see how rate hikes expectations developed in the last trimester relative to the cash bond yields.
At the beginning of October, the market was pricing barely one interest rate hike by the end of 2022. In a little over two months, interest rate hikes expectations almost tripled, with the market pricing nearly three rate hikes by the end of next year.
However, the most surprising factor is that while the short part of the yield curve rose with hikes expectations, 10-year yields mainly remained flat. Thirty-year yields, instead, dropped from 2% at the beginning of October to 1.73% at the beginning of December, then recovered slightly.
Many are quick to point to the possibility that the Federal Reserve might not go through with its tightening plan as it would burst the stock market bubble. Others suggest that growth might slow down, requiring a quick reversal of the Fed's tightening monetary policies.
However, we believe that the long part of the yield curve is totally out of grasp given that the economy is slowing down, but growth will remain above trend this year and the next. At the same time, inflation has become a more significant threat economically and politically, requiring a decisive turn in the Fed’s monetary policies.
We cannot forget that there are two other reasons why long-term yields remain compressed. One is Covid News concerning new lockdowns, and the omicron variant contributes to the flight to safe havens, which compresses real yields. The other is that long-term foreign investors looking for carry continue to enter currency-hedged US Treasuries. Indeed euro-hedged 10-year US Treasuries pay 85bps over the Bunds, and yen-hedged 10-year Treasuries offer 90bps over the JGBs.
We have trouble resonating with the idea that long-term yields will remain at current levels or even fall. Indeed, historically, when the Federal Reserve has engaged in an interest rate hiking cycle, long-term yields moved higher as well. If the compressing forces listed above continued to remain in place, long-term yields would rise slower than short-term yields. Yet, it’s impossible not to envision them moving higher, with the 10-year finally testing the pivotal 2% level next year.
There is another factor that might play against bond bulls: the fact that the market is still underestimating how aggressive the upcoming rate hike cycle might be. As a reference point, the interest rate hiking cycle between 2015 and 2018 had seen rates rising by 225bps amid a normal inflationary environment. The market is currently expecting the next tightening cycle to end when the Fed hiked rates by 150bps. That looks optimistic as we expect inflation to moderate next year but to remain sustained at levels that the market is not accustomed to. Investors should note that a selloff might be spurred as well by high inflation besides a rise in interest rates, forcing the Fed with its back against the wall.
Looking at the FOMC meeting tonight, it's inevitable to think of an upside for yields. Considering what my colleague John Hardy outlined in yesterday's FX update, three scenarios are possible:
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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.
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.
