Senior Fixed Income Strategist
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.
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.
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 end of the road
Emboldened by surging crude oil prices, Saudi Arabia makes waves on the international stage, as Crown Prince Mohammed bin Salman manages to create a World Champions League, after buying the UEFA Champion League franchise.
As the world embraces GLP-1 obesity wonder drugs, the people next in line to get a prescription stop caring about dieting and exercising, figuring that the drug will later solve all of their weight-related health problems.
With the US budget deficit spiraling above 10% of the GDP, the government is desperate to foster demand for US Treasuries. Under intense pressure from the White House, Congress makes income from government bonds tax-free.
After a criminal group deploys the most deceptive AI deepfake ever seen, generative AI becomes a national security threat. With public distrust soaring, governments crack down with harsh new laws, puncturing the AI hype.
To fix the divergence in the global trade and financial system, the largest deficit countries unite to negotiate new world trade terms. For surplus countries, the reset of the global economic model is a painful adjustment.
As discontent with Biden and Trump rises to fever pitch, Robert F. Kennedy Jr sees his support rising inexorably in the polls. On November 5, Kennedy wins the US presidential election, ushering in a new era in US politics.
Stepping up Japan's economic transformation in 2024, PM Kishida brings in a host of populist policies to boost domestic demand. As the GDP growth rate hits 7%, the BoJ is forced to abandons its yield curve control policy.
As people wake up to how little tax Europe’s billionaires are actually paying, the EU Commission implements a wealth tax of 2%. The tax sends shockwaves through Europe's luxury industry, with luxury giant LVMH plunging 40%.
