Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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FOMC skip doesn't mean rates are done with rising
Althea Spinozzi
Head of Fixed Income Strategy
Summary: US rates are in an uptrend: the US Treasury is selling large amounts of debt; CPI data might confirm stubborn inflation, and the Bank of Japan might pave the way for fewer Japanese investments abroad. Yet, leveraged investors’ net-short two-year Treasury positions might take yields in the opposite direction if a short squeeze ensues amid a dovish surprise. We believe that the latter is unlikely and that as yields increase, a window of opportunity will open for investors wanting to lock in enticing yields in risk-free Treasuries.
The US Treasury issuance spree begins this week
As discussed last week, the US Treasury must raise a net $116 billion weekly to replenish the Treasury General Account (TGA). That adds to the ongoing refinancing of existing maturities. Since the 2008 Global Financial Crisis until today, the US Treasury has raised that much cash for the TGA only eighteen times—ten of those during the Covid pandemic. On top of that, market conditions profoundly changed: interest rates are the highest they have ever been in the last fifteen years. Hence, such an issuance spree might further drain market liquidity, causing volatility. Today and tomorrow, the US treasury will issue $296 billion between coupons and bills, and we will look at any signs of cracks in liquidity.Tomorrow’s CPI readings, Wednesday's Fed’s updated economic forecasts, and the dot plot might confirm or remove July’s rate hikes bets.
So far, the market is pricing a 30% chance of a Fed rate hike on Wednesday and an 80% probability of a rate hike next month. Tomorrow’s CPI data might be pivotal for markets to confirm a July rate hike ahead of Wednesday’s FOMC meeting. The case for markets to erase a July rate hike is remote, as recent data show that the labor market is still strong. However, because the central bank remains data-driven, the Fed's updated forecasts and the dot plot on Wednesday might provoke a U-turn in expectation or solidify further a rate hike in July.Hedge funds are short US Treasuries ahead of the FOMC meeting.
According to a Bloomberg report, leveraged investors added to net-short two-year Treasury positions for an eleventh straight week. That’s the longest run-on record according to data going back to 2006. It’s important to note that leverage funds usually use bond futures in relative value trades, and net short positions fail to tell us what the other leg of the transaction is. However, net-short two-year Treasury positions still need to bottom, while 10-year positions did. Therefore, the overall expectations are for the Federal Reserve to remain hawkish for longer. This information is essential ahead of the FOMC meeting on Wednesday because if the FED decides to sound less hawkish than expected or even slightly dovish, US Treasuries might gain. If certain yield levels are hit as Treasuries soar, investors might be forced to cover their short positions, provoking a short squeeze. Although there is a higher chance of an aggressive Fed this week, the above is a tail risk that cannot be excluded. Bank of Japan.
Friday’s BOJ policy meeting will also be critical. Although the expectations are for Ueda not to change policies surrounding the yield curve control, the risk of a hawkish surprise remains, and it could severely affect rates in the US and Europe. Since the beginning of 2022, Japanese investors have decreased their holding of US Treasury debt. They own 15% of the $7.6 trillion in US Treasury securities held by foreign countries. Any hint at a change in curve control policies might see the selling of government bonds outside Japan, putting even more pressure on US Treasury yields. US Treasury yields look in an uptrend.
Two-year yields might break resistance at 4.63% this week to find strong resistance at 4.80% next.
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