The fight against inflation begins The fight against inflation begins The fight against inflation begins

The fight against inflation begins

Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Following yesterday's FOMC meeting, we expect the US yield curve to continue to flatten into the new year driven by high inflation and the overall tightening of USD liquidity. To contribute to higher interest rates in December might also be the debt ceiling suspension that would allow the Treasury to increase bills issuance, tightening liquidity further. In the short term, there is still potential for long term rates to fall. However, they need to soar long-term as the central bank prepares to hike interest rates. The market expects the BOE to hike interest rates today. However, there is room for Gilt yields to fall as there are signs that the market's hikes expectations might have run ahead of themselves.

FOMC takeaway: an unavoidable flattening of the US yield curve is to be expected.

We can summarize yesterday’s FOMC meeting within three points:

  1. Inflation is still transitory.
  2. Inflation is subordinated to jobs: until the economy reaches full employment, the Federal Reserve will not hike interest rates.
  3. Tapering begins, but it doesn’t imply rate hikes will follow.

The above was enough to keep the market in check for now, and it shifts the focus on upcoming jobs reports, including the nonfarm payrolls coming out tomorrow.

Although the market reaction was muted, something important happened as the FOMC statement was released. The breakeven rates began to rise, implying that tapering not only wouldn’t be enough to deter inflation but it could continue to lead to high price pressures. Powell was able to smooth corners at the press conference, saying that the pace of tapering will be adjusted according to future economic conditions, keeping open to a more aggressive pace of tapering.

Before drawing conclusions and understanding the consequences of the Fed's monetary decision for the bond market, it is crucial to consider the debt ceiling once again.

Until the debt ceiling is either suspended or raised, the US Treasury will not be able to increase its general account with the issuance of T-Bills. However, as soon as Congress removes the debt ceiling hurdles, we can expect the US Treasuries to increase its issuance of bills. Together with tapering, a higher T-Bill issuance will contribute to tightening liquidity putting upward pressure on rates.

Thus, we expect higher interest rates going forward. We expect the market to continue to price interest rate hikes earlier as unemployment falls and the Fed might need to taper more aggressively. Earlier interest rate hikes expectations and tapering and the debt ceiling suspension will add to bearish bond sentiment, contributing to higher rates also for long-term treasuries.

Therefore, we are talking about a bear flattening of the yield curve into 2022, where short-term yields will rise faster than long-term yields. Yet, as explained in this week’s “Fixed income market: the week ahead”, in the short term, there is still room for long-term yields to drop as short interest in TLT, the iShares ETF that tracks US Treasuries with 20+ years maturity has the highest open short interest position on record, exposing it to a short squeeze.

Bank of England: today's interest rate hike might not be what the market expects.

The BOE might deliver an interest rate hike today, but not the way the market expects, provoking an unanticipated bull steepening of the Gilt yield curve.

So far, the market has priced a much more aggressive interest rate hike cycle in the UK than in the US. Additionally, the yield curve remains pretty flat, with the spread between 30-year and 10-year Gilt yields trading at 14bps, thus close to inversion. It's unlikely that the central bank will want to risk the yield curve to invert, and it is extremely unlikely that all members agree to such an aggressive rate hike pace.

Suppose today's rate hike decision is not going to be unanimous. In that case, that might imply that future interest rate hikes might receive even less support, pushing back on current market expectations. That could provoke a strong rally throughout the entire Gil curve. Yet, the front part of the yield curve is likely to benefit the most, with 2-year Gilt yields likely to break support at 0.60% falling to test new support at 0.51%. 

Source: Bloomberg and Saxo Group.

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