A critical week for US Treasuries.
This week's Federal Reserve meeting will dictate sentiment across assets. The market is waiting for indications regarding interest rate hikes for this year and hearing what intentions the central bank has concerning reducing its nearly $9 trillion balance sheet.
Currently, the market is pricing four interest rate hikes this year, starting in March. The big question is whether the Fed will match, disappoint or exceed such expectations. We see three outcomes playing out this week:
- The Fed matches the market's expectations. In this case, investors' focus would shift towards the drawdown of its balance sheet. Suppose there are indications that the Fed’s balance sheet needs to be shrunk faster compared to previous tightening periods due to inflationary pressures. In that case, we could witness a selloff concentrated in long-term Treasuries and assets with high duration, such as Tech stocks.
- The Fed exceeds the market's expectations. We believe it to be the least likely scenario. In this case, we will witness a fast bear-flattening of the yield curve as the market will need to price a more aggressive rate hike schedule.
- The Fed disappoints the market's expectations. In this case, we might see the yield curve bull-steepening as the front part of the yield curve will need to reconsider the number of interest rate hikes this year. Wording concerning the balance sheet reduction will be critical as an early and aggressive start of its wind-down could lift long-term yields, steepening the yield curve further.
Of all the options above, I believe the last one to be the most probable. Indeed, the central bank has shown concerns regarding the current flat shape of the yield curve on several occasions. Therefore, it wouldn’t make sense to see an overly aggressive Powell vowing for a fast pace of rate hikes because that would rapidly flatten the yield curve.
It’s more probable that the Federal Reserve would seek to combine interest rate hikes with an early and gradual reduction of its balance sheet to preserve the yield curve's steepening on one side and to tighten the economy more efficiently on the other. By implementing balance sheet policies, the central bank will affect long-term yields directly linked with mortgage and borrowing costs. However, if the Fed were to hike rates by 50bps in March, as some have suggested, it will have little impact on supply-chain bottlenecks or energy prices.
Suppose Powell looks more inclined to combine interest rate hikes with a balance sheet reduction on Wednesday. In that case, the market might reconsider the number of hikes for 2022 because the central bank might not need to be as aggressive as expected.
Yet, we have to be prepared for a year where the Federal Reserve might move and change messages at each meeting. While last year the officials were patiently trying to prove that inflation was transitory, this year, they are pressured by the White House and its constituents to fight it. Thus, prepare for a volatile year in markets.
Economic data are also going to be pivotal for the week ahead. The US will release preliminary data on last quarter's gross domestic product on Thursday. Data on personal income and spending for December will also be released on Friday. Both data might show that the economy is losing momentum, adding to worries concerning a slowdown in growth that could keep long-term yields compressed.
We cannot finish talking about Treasuries without mentioning the escalation of geopolitical tensions between the US and Russia, which provoked a fast drop of yields across the yield curve on Friday. If tensions escalate, we can expect yields to remain compressed or even dropped amid a flight to safety.
Today, yields have fallen further, with 10-year yields close to testing resistance at 1.70%.