The front part of the US yield curve is not done

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.