Head of Fixed Income Strategy
Summary: The bond market's reaction was muted amid a hawkish Federal Reserve's meeting. Investors decided to focus on shorter-term economic dynamics such as the Delta variant dismissing signals of aggressive tapering and a Fed fund rate forecast of 1.8% for 2024, much higher than the Euro Dollar market pricing. Bond yields are likely to trade rangebound between 1.26% and 1.4% until it's evident inflation will not be transitory. Dropping longer-term yields drive the flattening of the yield curve, posing a problem if the central bank needs to hike interest rates soon. Tapering should help to steepen the yield curve unless US economic data continue to come in weak, pinning down long term yields.
In light of yesterday's FOMC meeting, the muted market reaction indicates that investors continue to focus on shorter-term economic dynamics such as Delta and employment rather than on inflation.
However, we believe that the Federal Reserve was relatively dovish yesterday:
The yield curve flattened considerably, with the 5s30s year spread falling below 100bps for the first time since August last year.
The flattening was driven by 30-year yields dropping 4bps on the day, while 5-year rose only by 2.5bps. Longer-term yields dropped faster than shorter-term yields showing that the market is somewhat concerned about the Fed making a policy mistake.
The problem with dropping long-term yields is that if interest rates need to be hiked soon, it would be best for the yield curve to be steeper to avoid an inversion if the front part of the yield curve rises fast. In that respect, tapering should help unless US economic data continue to come in weak, pinning down the long part of the yield curve.
Today’s preliminary PMI indexes could confirm the market’s cautious stance if they come in weak as in August. Thus, bond yields might not move much until the next inflation read, trading rangebound between 1.26% and 1.4%.
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