The fight against inflation begins

The fight against inflation begins

Bonds
Althea Spinozzi

Senior Fixed Income Strategist, Saxo Bank Group

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.

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.