It’s not the Federal Reserve, it might be the market to be behind the curve
Senior Fixed Income Strategist
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.
Market expectations are way too moderate ahead of what it can be a hawkish Fed.
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.
What are our expectations for today's FOMC meeting?
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:
- The dovish case (low probability): we might see a correction in rate hikes expectations and the front part of the yield curve dropping. Yet, it will be unlikely to see 10-year yields dive below 1.40%.
- The base case scenario (60+% odds): the Fed delivers a doubling of the speed of tapering by $30 billion as of this meeting, crystalizing its dovish stance. In this case, it's impossible not to envision long-term rates rising and the yield curve steepening slightly before resuming its flattening megatrend in 2022. Yet, 10-year yields will still remain below 1.70%.
- The hawkish case (30%+ odds): the Fed delivers a doubling of the taper speed or faster and sufficiently credible language on the timing of the lift-off to bring the March FOMC meeting into view as a possibility. In this case, the whole curve will need to shift higher, yet the front part of the yield curve will rise faster than the long part. Even in this case, we don't believe 10-year yields will be able to break above their 2021 peak at 1.75% due to the compressing forces we have highlighted above.
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