It’s It’s It’s

It’s not the Federal Reserve, it might be the market to be behind the curve

Bonds
Althea Spinozzi

Senior Fixed Income Strategist, Saxo Bank Group

Summary:  The long part of the US yield curve looks out of grasp. The market might be underestimating the Federal Reserve's concern for inflation and the upcoming tightening cycle. The probability for long-term yields to rise and the yield curve to steepen on the back of today's FOMC meeting is high. Yet, we don't expect 10-year US Treasury yields to break above the range they have been trading in throughout this year due to current yield-compressing factors.


Ahead of tonight’s FOMC, we would like to highlight the importance of interest rates expectations when considering possible yield curve moves. To do that, it's key to see how rate hikes expectations developed in the last trimester relative to the cash bond yields.

At the beginning of October, the market was pricing barely one interest rate hike by the end of 2022. In a little over two months, interest rate hikes expectations almost tripled, with the market pricing nearly three rate hikes by the end of next year.

However, the most surprising factor is that while the short part of the yield curve rose with hikes expectations, 10-year yields mainly remained flat. Thirty-year yields, instead, dropped from 2% at the beginning of October to 1.73% at the beginning of December, then recovered slightly.

Many are quick to point to the possibility that the Federal Reserve might not go through with its tightening plan as it would burst the stock market bubble. Others suggest that growth might slow down, requiring a quick reversal of the Fed's tightening monetary policies.

However, we believe that the long part of the yield curve is totally out of grasp given that the economy is slowing down, but growth will remain above trend this year and the next. At the same time, inflation has become a more significant threat economically and politically, requiring a decisive turn in the Fed’s monetary policies.

We cannot forget that there are two other reasons why long-term yields remain compressed. One is Covid News concerning new lockdowns, and the omicron variant contributes to the flight to safe havens, which compresses real yields. The other is that long-term foreign investors looking for carry continue to enter currency-hedged US Treasuries. Indeed euro-hedged 10-year US Treasuries pay 85bps over the Bunds, and yen-hedged 10-year Treasuries offer 90bps over the JGBs.

Source: Bloomberg and Saxo Group.

Market expectations are way too moderate ahead of what it can be a hawkish Fed.

We have trouble resonating with the idea that long-term yields will remain at current levels or even fall. Indeed, historically, when the Federal Reserve has engaged in an interest rate hiking cycle, long-term yields moved higher as well.  If the compressing forces listed above continued to remain in place, long-term yields would rise slower than short-term yields. Yet, it’s impossible not to envision them moving higher, with the 10-year finally testing the pivotal 2% level next year.

There is another factor that might play against bond bulls: the fact that the market is still underestimating how aggressive the upcoming rate hike cycle might be. As a reference point, the interest rate hiking cycle between 2015 and 2018 had seen rates rising by 225bps amid a normal inflationary environment. The market is currently expecting the next tightening cycle to end when the Fed hiked rates by 150bps. That looks optimistic as we expect inflation to moderate next year but to remain sustained at levels that the market is not accustomed to. Investors should note that a selloff might be spurred as well by high inflation besides a rise in interest rates, forcing the Fed with its back against the wall.

What are our expectations for today's FOMC meeting?

Looking at the FOMC meeting tonight, it's inevitable to think of an upside for yields. Considering what my colleague John Hardy outlined in yesterday's FX update, three scenarios are possible:

  • The dovish case (low probability): we might see a correction in rate hikes expectations and the front part of the yield curve dropping. Yet, it will be unlikely to see 10-year yields dive below 1.40%.
  • The base case scenario (60+% odds): the Fed delivers a doubling of the speed of tapering by $30 billion as of this meeting, crystalizing its dovish stance. In this case, it's impossible not to envision long-term rates rising and the yield curve steepening slightly before resuming its flattening megatrend in 2022. Yet, 10-year yields will still remain below 1.70%.
  • The hawkish case (30%+ odds): the Fed delivers a doubling of the taper speed or faster and sufficiently credible language on the timing of the lift-off to bring the March FOMC meeting into view as a possibility. In this case, the whole curve will need to shift higher, yet the front part of the yield curve will rise faster than the long part. Even in this case, we don't believe 10-year yields will be able to break above their 2021 peak at 1.75% due to the compressing forces we have highlighted above.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo Markets
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Support Centre
For existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo Markets is a registered Trading Name of Saxo Capital Markets UK Ltd (‘SCML’). SCML is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo Markets assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.