Federal Reserve: the yield curve might bear-steepen before resuming its bear-flattening trend.
We have talked about it a lot, and last week’s CPI numbers leave no doubt: the Federal Reserve cannot hold its dovish stance any longer as there are increasing signs of non-transitory inflation in the economy. Not only, but the full employment mandate is close to being fulfilled, with jobs recovering fast and the unemployment rate dropping below pre-pandemic levels across all sectors except for travel and leisure. Therefore, the continuous stimulus that the economy receives through tapering it’s unnecessary and counterproductive. Hence, it makes sense to increase the pace of tapering to be done with it as soon as possible.
Our expectation is for the Federal Reserve to double the rate of tapering from $15bn to $30bn per month. That way, the central bank will be done with it by the first quarter of 2022, leaving open the possibility for an interest rate hike as soon as May or even in March, if required.
However, an acceleration of the tapering rate will not catch the market by surprise. The dot plot could be more surprising, as it might show an acceleration in interest rate hikes expectations by FOMC members further out of the curve.
Throughout 2021, FOMC participants have increased short-term interest rate hikes projections. Yet, longer-term forecasts continue not to be aggressive, with the dot plot showing only 150bps rate hikes by 2024. As a reference, during the rate hike cycle between 2015 and 2018, the Fed fund target rate rose from 0.25% to 2.50%. It makes the expectations of only 150bps rate hikes seem conservative in an environment characterized by intense inflationary pressures. Indeed, inflation wasn’t an issue six years ago.
Therefore, there is a big chance that the dot plot will show interest rate projections little changed for 2022 and 2023, but they might accelerate in the longer term. Consequently, it’s possible that the US yield curve will bear-steepen before it will resume its bear-flattening trend, which we still believe will be the dominant move for next year.
The Federal Reserve will welcome a steepening of the yield curve. Indeed, the yield curve is the flattest it has been whenever the central bank began to hike interest rates in the past 35 years, except for 1999. However, it’s impossible to draw a parallel as 10-year yields at that point were at 6%.