Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
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Chief Investment Strategist
The front part of the US yield curve is not done
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Powell succeeded in calming and unnerved bond market. However, yesterday's 2-year US Treasury auction was disappointing following the 5bps hike in IOER/RRP rate. It leads us to believe that today and tomorrow 5-, and 7-year auctions might be vulnerable to investors' demand ahead of the personal consumption data. The divergence between the bond market and eurodollar futures reveals that yields in the front part of the yield curve are poised to rise much higher.
The market has all the reasons to take the Federal Reserve with a pinch of salt. Powell announced that the central bank would start talking about tapering, despite rejecting the idea entirely until last week. Additionally, he hiked the IOER/RRP rate by 5bps in a move branded as "technical" at the same meeting.
The actions of the Fed speak more than a thousand words. Although the Fed is in complete denial, it did hike interest rates last week. The abrupt bear-flattening of the yield curve indicated that the move was not priced in by investors as they stuck to the Fed’s dovish communications. It seems that the market is committing the same mistake all over again. Following the speeches of Mester, Williams and Powell's testimony to Congress, investors are ready to believe in whatever the Fed says to them blindly.
What could have been a nasty 2-year auction turned out to be just disappointing, with the yield tailing 0.05bps, the biggest since July 2020. Foreign investors demand dropped considerably from last month’s 57.1% to 50.6%. Yet, weak bidding metrics failed to move the market in a sign that the bond market buys into the Fed's message despite last week's massive reversal. We see a divergence in expectations between the bond market and eurodollar futures. The latter suggests a rate hike by the end of 2022, while the bond market discounts only a 2023 rate hike. A yield of 0.50%, double to what 2-year notes are offering now, would better indicate future rate hike expectations. However, it doesn't seem bond investors will move forwards until Federal Reserve becomes more hawkish.
The picture that the bond market is providing is quite pessimistic because it might reflect the expectations that the measures taken by the Federal Reserve to hike the IOER/RRP rate and to unwind its corporate bond portfolio gradually might be too much for the market to tolerate. Yet, the central bank raised growth and inflation forecasts signalling that more tightening might be needed. Thus, although things can change quickly after summer, we might still be facing a calm summer ahead with 10-year yields trading rangebound amid lower liquidity.
Don’t get too comfortable yet: this week's personal consumption data may still shake up things. The PCE Index is the favourite inflation indicator of the federal reserve. It is expected to rise to 3.4% from 3.1% YoY in May, which would be the highest reading since 1991. The belly of the curve will be most vulnerable to any surprise, and today and tomorrow's 5- and 7-year US Treasury auctions might provide insight into how investors are positioning ahead of this data.
The belly of the curve has suffered from weak demand for almost a year now. During the latest 5-year US Treasury auction in May, we saw the bid-to-cover ratio rising above the five year average for the first time since August, signalling improved demand for these securities. Yet, the higher demand might have been caused by leakage of liquidity from money markets. Today it will be crucial to see if demand deteriorates following the 5bps rate hike in IOER/RRP. Suppose the bid-to-cover ratio were to fall again below the 5-year average. In that case, it might mean that the rate hikes in the money market are drying liquidity up on the front part of the yield curve, making it more vulnerable to inflation surprises. Thus, tomorrow's 7-year auction could be more volatile and moving markets substantially. Although we have seen demand for 7-year notes improving since their dreadful auction back in February, the bid-to-cover remains well below the five-year average Latest Market Insights
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