Markets are heading toward the weekend with a clear idea: developed central banks on both sides of the Atlantic are done with their interest rate hiking cycle. However, a hawkish bias will be maintained as the fight against inflation is not over.
Central banks' higher-for-longer message explains the bull flattening of yield curves. Typically, the yield curve would bull-steepen as the hiking cycle ends, and investors start to price for upcoming interest rate cuts. However, that didn’t happen this time around because central banks are set for a “table mountain" strategy, as doubted by the Bank of England’s chief economist Huw Pill, which implies keeping the benchmark rate high for long until inflation is clearly under control. Long-term rates dropping faster than short-term rates can be explained by the fact that markets are starting to see a sensible deceleration of developed economies, increasing the likelihood of a recession.
Yet, is the rally that we have witnessed this week sustainable? I don't believe so. The reason is simple: there is too much selling pressure for yields to continue to drop.
The Federal Reserve is proceeding "carefully," while the US Treasury has increased coupon issuance to the highest since 2021.
The most dovish part of Powell's speech is the comments regarding the labor market. He seems to believe that the central bank will be able to fight inflation without slowing down the labor market significantly. That means that there might be no need for labor weakness in order to cut rates in the future. However, these remarks came together with the notion that tighter financial conditions must be persistent; hence, long-term yields need to remain elevated. That keeps the door open to further rate hikes or a potential tweak of quantitative tightening in case long-term yields continue to drop.
Therefore, nothing has materially changed. The Fed remains hawkish, while quantitative tightening (QT) will continue to work in the background, further tightening monetary conditions. That, combined with the fact that the US Treasury will need to continue to expand coupon issuance into the new year while foreign demand for these securities is slowing and the yield curve is steepening (therefore, market participants are buying the front end while selling long end), means that the long part of the yield curve is more likely to rise rather than drop.
Next week, the Treasury is selling $112 billion in coupon issuance, increasing 10-year and 30-year bonds to the highest since 2021. That's almost double what has been issued during the decade preceding Covid. However, the demand side has noticeably deteriorated, with the Federal Reserve turning from a buyer into a net seller.