No country for tightening, but captions tell a different story
Senior Fixed Income Strategist
Summary: Inflation is returning to be an influential factor in the Federal Reserve's monetary policy decisions. Thus, an interest rate hike will likely happen as early as this year, regardless of job numbers. However, US treasury yields will continue to trade rangebound between 1.50% to 1.70% until the central bank doesn't engage more actively in tapering talks. US yields will continue to be capped by rotation and the excessive liquidity in money markets. Expect the yield curve 2s10s and especially the 5s30s to continue to bear-flatten as inflationary pressures and interest rate hikes will be concentrated on the front part of the yield curve.
The Federal Reserve changed slightly its “lower for longer” message, which has been trying to convey since the beginning of the year. Suddenly, the dot plot shows at least two rate hikes for 2023, while before, it showed no rate hikes until 2024. So longer is slowly pushed forward, and the market is trying to make sense of an increasingly conflicting message.
Indeed, the dot plot estimates clash with the FOMC economic forecasts. The central bank revised the Personal Consumption Expenditure Index (PCE) upwards for 2021 from 2.2% to 3%, in 2022 from 2.0% to 2.1% but kept it unchanged for 2023. That suggests that a sudden increase of the Federal Funds Rate in 2023 is misplaced because inflationary pressures will build up this year and the next. Thus, a rate cut may be necessary as soon as this year, and not in two. Interestingly, the estimated unemployment rate did not change substantially, sending out a signal that the Fed might need to hike interest rates regardless of jobs numbers. Therefore, the central bank puts back on the podium inflation, placing jobs in second place when setting monetary policies.
This is a crucial point for bond investors because there might start to be doubts about the transitory nature of inflation among FOMC members. Thus, US Treasury yields will be more responsive to inflationary data shifts than what we have witnessed during the last weeks.
Yields are capped by rotation and the excessive liquidity in money markets
The forces that have driven US Treasury yields lower amid the highest CPI read since the 2008 Global Financial Crisis are still relevant and actively compressing yields.
One of these is the excessive liquidity that persists within the money market space. The market is so desperate to avoid negative short-term yields that it accepts to put cash at work to longer maturities. Bloomberg even reported that some are extending duration substantially, buying 10-year US Treasuries. This phenomenon is keeping the front part of the yield curve in check.
On the long part of the yield curve, yields are compressed by rotation from lower-yielding government bonds to US Treasuries. We have gotten some clues of this phenomena during the latest German Bund auctions, as bidding metrics are persistently weak. Simultaneously, foreign investors demand at US Treasury auctions is strengthening. That's not surprising given that once hedged against a three month rolling forward, 10-year US Treasuries offer 0.8% in yield, almost 100 basis points over the German Bunds. Thus, most investors will not want to pay for holding German Bunds while they can accrue interests by holding the US safe haven.
Therefore, although monetary policies have turned slightly hawkish, we expect 10-year yields to continue within the tight range they have been trading in since March within 1.5% and 1.7%. Yields will break above 1.7% only when the Federal Reserve will be actively engaging with tapering talks.
A small tightening in disguise has already happened
A move entirely underplayed by Jerome Powell has been the one to hike the rate on its overnight reverse repurchase-agreement facility (RRP) by 5 basis points to 0.05%. The Fed has also increased interests paid on excess reserve by 5 basis points to 0.15%. Although the Fed Chair labelled the move as a technical adjustment, we cannot avoid thinking that it is a clear sign of tightening financial conditions. The move has been noticeable in the money market, provoking yields slightly higher, although the short part of the curve up to two months continues to remain negative.
Expect a flatter yield curve
In the past few years, a flatter yield curve has been synonymous with bullishness. Not this time. After the FOMC press conference, the belly of the yield curve shifted higher on expectations of earlier interest rate hikes. The longer part of the yield curve fell considerably, with 30-year yields leading losses provoking a fast flattening of the yield curve. Thus, we are witnessing to a bear-flattener. We expect the yield curve to continue to bear-flatten as the Federal reserve become more vocal about interest rates hikes. Demand for the long part of the yield curve will continue to be supported in light of foreign investors' rotation. Five-year yields are going to be more exposed by a shift higher.
The reason why 30-year yields are falling lies within inflation expectations and interest rate hikes being concentrated in the front part of the yield curve. Following a period of interest rate rises, the market would expect a period of falling interest rates. A good proxy for moves on the long part of the yield curve is the 5-year 5-year forward, which shows inflation expectations in five years starting from 5-year from now.
Within this context, there is the potential for both the 2s10s and 5s30s spreads to tightening to 100bps from 133 and 126bps, respectively.