Macro: Sandcastle economics
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The recent selloff shows that markets are not ready for tighter monetary policies
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The recent selloff in US Treasuries points to changing monetary policies' expectations. The less transitory inflation is, the more aggressive central banks will need to turn, and the selloff in the bond market will continue. That's why this Friday's PCE figures remain in the spotlight.
On a calmer day for financial markets, it’s useful to take a step back to better understand what are the trends that are driving risk sentiment in the bond market. I can currently point to four main drivers of US Treasuries:
- Supply and demand
- Debt ceiling dilemma
- Inflation expectations
- Monetary policies’ expectations
The above can be used as a compass when analyzing the recent selloff in US Treasuries and it shows that the fast rise in yields can be attributed only by a shift in monetary policy expectations.
Supply and demand
This week the US Treasury sold 2-year, 5-year and 7-year notes and despite demand was slightly lower compared to summer, it was good enough not to spill volatility in the secondary market. Bidding metrics deteriorated considerably only for the 2-year notes, which might be linked to the debt ceiling dilemma. However, demand for the belly of the curve remained decent leading us to believe that the bear steepening of the yield curve has not been caused by supply-demand discrepancies
Debt ceiling dilemma
Discussions concerning the debt ceiling issues are taking a central stage as Janet Yellen said that the US might default on its debt already by the 18th of October, a date eerily close. However, the reaction to that news should be a bear flattening of the yield curve, not a bear steepening led by the belly of the curve as we have seen in the past few days. Indeed, a default would provoke short-term rates higher, while the long part of the yield curve, 10-year yields in particular, will drop serving as a safe-haven exactly as they did during previous Debt ceiling crisis.
Therefore, only the lack of demand for the 2-year note auction can be reconducted to the debt ceiling crisis, while the selloff throughout longer maturities cannot be linked to this topic.
Inflation expectations
Looking at breakeven rates, we can safely say that market’s inflation expectations didn’t advance since summer. Thus, breakevens are not driving the fast rise in yields. It’s key to recognize because it implies an acceleration in real yield, which poses a threat to risky assets.
Monetary policies’ expectations
We can confidently say that the recent move higher in nominal and real yields has been caused by changing monetary policies’ expectations. Indeed, the Eurodollar strip is pricing two rate hikes by the end of 2022. While in 2021, the market expects already a rate hike of 15bps. That’s a massive change from a few weeks ago, when the market was biting into the Fed’s Average Inflation Targeting (AIT) framework and rate hikes to begin in 2023 despite rising signs of more permanent inflation. It shows that last week’s central banks’ meetings printed the idea in markets that monetary policies are just about to turn more hawkish than what the market expects.
A big question however remains: will rates continue to rise? Our short answer to that question is yes. However it depends on how inflation turn out to be more less transitory. That’s why despite the market is calming down at the moment, the PCE figures and University of Michigan survey coming out of the US are pivotal for the bond market. The less transitory inflation is, the more aggressive central banks will need to be, and the selloff in the bond market will continue.
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