Despite making sense for the Federal Reserve to begin talking about a balance sheet reduction, the market remains on hedge because it’s unsure about the consequences.
The last time the Fed announced it would allow maturing assets to run off the balance sheet was in June 2017, 18 months after the Fed raised interest rates. This time around, Fed officials are talking about interest rate hikes and shrinking the balance sheet in the same year, making a case for higher yields more robust.
Another point needs to be highlighted: if the Fed is looking to shrink its balance sheet already in 2022, why does it continue to expand it? It doesn’t make sense! That’s why there is a possibility that during January’s FOMC meeting, the Fed announces an immediate termination of purchases. With bond purchases ceasing this month, The Fed opens up the way for an interest rate hike already March, followed by an announcement of the balance sheet runoff as soon as in June.
An early end to tapering this month would make sense also under the perspective that the US Treasury will cut its bond issuances as fiscal needs have diminished sensibly compared to the 2020 and 2021 pandemic years. Thus, demand for bonds should continue to remain supported, limiting volatility.
It is not easy to say how high long-term US Treasury yields can go. Indeed, a lot will depend on how aggressive the balance sheet's runoff will be. In 2017, the amount of assets allowed to runoff was initially capped at $10bn per month in total for Treasuries and Mortgage-Backed Securities and gradually increased. The Fed might want to adopt the same strategy or, it might need to be more aggressive depending on how many times it will need to raise interest rate hikes this year.
Additionally, as we pointed out last week, demand for US Treasuries will increase as yields rise. Many investors are still locked in ultra-low yields globally. The US safe-haven can still provide a pick-up over global benchmarks once hedged against FX risk. As an example, EUR-hedged 10-year US Treasuries provide 92bps above the German Bunds.
Therefore, it is safe to assume that the rise in long-term yields will be contained until more details will surface concerning the Fed's balance sheet runoff. In contrast, the front part of the yield curve will continue to rise on the expectations of faster and aggressive interest rate hikes. Thus, we expect a bear flattening of the yield curve to continue.
This week, Fed officials have no scheduled appearance as they have entered the quiet period preceding the FOMC meeting. Yet, it is a week packed with economic data such as the Empire State manufacturing index, Building Permits, and the Philly Fed manufacturing index. We do not expect these data to alter market expectations of an interest rate hike by March. On Wednesday, we have a 20-year US Treasury auction worth following. The 20-year tenor is not as popular as the other, and lack of demand could cause volatility in the long part of the yield curve.
European sovereigns: ECB minutes and inflation.
After European sovereign yields dropped suddenly last week with 10-year Bund yields testing support at -0.10%, today they look once again on the rise. The market has started to price an ECB interest rate hike as early as October. On Thursday, the ECB will release its monetary policy meeting accounts, showing how worried officials are about inflation upside risk, influencing hiking expectations. On the same day, a second reading on euro-area consumer prices will be released, which preliminary data showed to have jumped to 5%.
Sovereign bond issuance continues this week with Germany selling 5-year and 15-year bonds, France selling 3-year, 5-year, and 7-year Notes, Spain selling 5-year, 8-year, and 18-year Bonds.
We expect bidding metrics to remain sustained in European sovereign auctions; however, volatility will remain high amid fading ECB support and higher yields in the US. We expect sovereigns with the highest beta, such as Italy, to be more vulnerable.