Dear reader, this will be the last Fixed income the week ahead before the summer break. I will finally go to Italy after more than a year of Danish confinement to get plenty of pasta, pizza and sun. The week ahead will resume on the second half of August. However, I will be returning at the end of the month for our regular monthly Fixed Income Update webinar. You can sign up by clicking on it here.
While many of us are heading towards a well-deserved vacation, the market is yet to pack its bags. Friday’s strong nonfarm payrolls failed to revive the reflation trade as the report gave contradictory messages. Jobs grew together with the unemployment rate. Wages increased the most since the Global Financial Crisis of 2008/09, but working hours fell. It’s clear that although the job market is recovering, we are still far away from the Fed’s full unemployment target. Hence, the market expects the central bank to continue to remain accommodative.
Yet, we believe that investors are misreading the central bank message. While the full employment vision has dominated monetary policies since the Covid-19 pandemic, the last FOMC meeting sent contradictory messages. The Federal Reserve hiked interest rates in two key money market facilities and opened up to tapering despite jobs numbers missed expectations for two months in a row. We believe it is clear that the central bank is shifting its focus from jobs to inflation pressures.
Therefore, this week's minutes will be critical as they may give an idea of whether FOMC members are starting to be less confident about inflation's transitory nature and when the Fed could begin tapering its asset purchases. Regardless, US Treasury yields will most likely continue to trade rangebound until the Federal Reserve begins to engage more actively with tapering talks.
Excess liquidity, the resumption of a debt ceiling limit, and the Treasury General Account drawdown will continue to squash US Treasury yields. We may be facing T-Bills paydowns (when the government issues less debt than what is maturing), which, combined with a reduction of the TGA, translates into lower yields in the front part of the yield curve. Because T-Bills are already close to 0%, the Federal Reserve will soon need to decide whether to accept negative yields in the front part of the yield curve or to taper more aggressively than the market anticipates.
Concerns regarding a spike in volatility are rapidly growing. Money market guru Zoltan Pozsar begins to be troubled about the growing size of the Fed’s Reverse Repurchasing Facility (RRP). According to him, the sudden surge of RRP usage following the 5bps hike from the Federal Reserve implies that a large part of cash is rotating from bills to the RRP facility. However, T-Bills demand is crucial for future issuances. Zoltan says that the RRP is becoming an "active tool that sucks the deposits away that banks decided to retain”.
How does all the above come to play for bond investors? Everything is pointing to a negative T-Bills rate in the short term and a bear flattening of the US yield curve in the mid-term. It doesn't mean that long term yields will continue to fall. They might fall and break below 1.40% in the short-term, finding support next at 1.20%. Yet, as inflationary pressures become less transitory, we might see the yield curve shifting higher while bear-flattening.