A small tightening in disguise has already happened
A move entirely underplayed by Jerome Powell has been the one to hike the rate on its overnight reverse repurchase-agreement facility (RRP) by 5 basis points to 0.05%. The Fed has also increased interests paid on excess reserve by 5 basis points to 0.15%. Although the Fed Chair labelled the move as a technical adjustment, we cannot avoid thinking that it is a clear sign of tightening financial conditions. The move has been noticeable in the money market, provoking yields slightly higher, although the short part of the curve up to two months continues to remain negative.
Expect a flatter yield curve
In the past few years, a flatter yield curve has been synonymous with bullishness. Not this time. After the FOMC press conference, the belly of the yield curve shifted higher on expectations of earlier interest rate hikes. The longer part of the yield curve fell considerably, with 30-year yields leading losses provoking a fast flattening of the yield curve. Thus, we are witnessing to a bear-flattener. We expect the yield curve to continue to bear-flatten as the Federal reserve become more vocal about interest rates hikes. Demand for the long part of the yield curve will continue to be supported in light of foreign investors' rotation. Five-year yields are going to be more exposed by a shift higher.
The reason why 30-year yields are falling lies within inflation expectations and interest rate hikes being concentrated in the front part of the yield curve. Following a period of interest rate rises, the market would expect a period of falling interest rates. A good proxy for moves on the long part of the yield curve is the 5-year 5-year forward, which shows inflation expectations in five years starting from 5-year from now.
Within this context, there is the potential for both the 2s10s and 5s30s spreads to tightening to 100bps from 133 and 126bps, respectively.