Head of Fixed Income Strategy
Summary: The probability for the Federal Reserve to announce an immediate end of purchases as soon as next week is rising. If that were happening, it would open up the way to a first interest rate hike in March and an announcement of the balance sheet runoff as soon as June. We expect the yield curve to continue to bear-flatten until a clear communication surrounding the balance sheet reduction. Depending on how aggressive it will be, long-term rates can increase considerably. In Europe, the ECB minutes for December will be in the spotlight as concerns regarding high inflationary pressures surge among policymakers.
US Treasury yields resumed their rise last Friday as the US Treasury sent its quarterly survey of primary dealers asking their views on how a Federal Reserve balance sheet runoff might impact its financing needs and issuance decisions. Ten-year US Treasuries rose by 7bps to 1.78%, aiming to their resistance level at 1.8%, first tested last Monday since January 2020, but rejected. The short part of the yield curve also rose, with 2-year yields rising quickly to 0.96%, the highest since February 2020 and close to the pivotal 1% level.
Investors are starting to resonate with the idea that the Federal Reserve will need to complement the imminent interest rate hiking cycle with a reduction of the balance sheet to fight sustained inflation levels. In that case, long-term yields will rise together with short-term yields, tightening the economy more proactively. Indeed, mortgages and borrowing costs are impacted by 10-year yields rather than short-term rates. Therefore, a rise in long-term yields is necessary if the Fed wants to cool off the economy.
Additionally, a balance sheet runoff might enable the Fed to be less aggressive with interest rate hikes, letting the yield curve do a lot of the heavy lifting. At that point, there might not be a need to hike interest rates five times, as Waller recently suggested. It might be possible to limit them to three, catering for a gradual tightening and avoiding the yield curve to further flatten from now. The 2s10s spread is around 80bps, while the 5s30s spread trades at 55bps. Rapid interest rates hikes might lead the yield curve to an inversion, which historically has been a strong indicator of future recessions. It makes sense that the Federal Reserve wants to reduce such risk to a minimum and looks to use all the tools in its power to get a steeper yield curve.
Despite making sense for the Federal Reserve to begin talking about a balance sheet reduction, the market remains on hedge because it’s unsure about the consequences.
The last time the Fed announced it would allow maturing assets to run off the balance sheet was in June 2017, 18 months after the Fed raised interest rates. This time around, Fed officials are talking about interest rate hikes and shrinking the balance sheet in the same year, making a case for higher yields more robust.
Another point needs to be highlighted: if the Fed is looking to shrink its balance sheet already in 2022, why does it continue to expand it? It doesn’t make sense! That’s why there is a possibility that during January’s FOMC meeting, the Fed announces an immediate termination of purchases. With bond purchases ceasing this month, The Fed opens up the way for an interest rate hike already March, followed by an announcement of the balance sheet runoff as soon as in June.
An early end to tapering this month would make sense also under the perspective that the US Treasury will cut its bond issuances as fiscal needs have diminished sensibly compared to the 2020 and 2021 pandemic years. Thus, demand for bonds should continue to remain supported, limiting volatility.
It is not easy to say how high long-term US Treasury yields can go. Indeed, a lot will depend on how aggressive the balance sheet's runoff will be. In 2017, the amount of assets allowed to runoff was initially capped at $10bn per month in total for Treasuries and Mortgage-Backed Securities and gradually increased. The Fed might want to adopt the same strategy or, it might need to be more aggressive depending on how many times it will need to raise interest rate hikes this year.
Additionally, as we pointed out last week, demand for US Treasuries will increase as yields rise. Many investors are still locked in ultra-low yields globally. The US safe-haven can still provide a pick-up over global benchmarks once hedged against FX risk. As an example, EUR-hedged 10-year US Treasuries provide 92bps above the German Bunds.
Therefore, it is safe to assume that the rise in long-term yields will be contained until more details will surface concerning the Fed's balance sheet runoff. In contrast, the front part of the yield curve will continue to rise on the expectations of faster and aggressive interest rate hikes. Thus, we expect a bear flattening of the yield curve to continue.
This week, Fed officials have no scheduled appearance as they have entered the quiet period preceding the FOMC meeting. Yet, it is a week packed with economic data such as the Empire State manufacturing index, Building Permits, and the Philly Fed manufacturing index. We do not expect these data to alter market expectations of an interest rate hike by March. On Wednesday, we have a 20-year US Treasury auction worth following. The 20-year tenor is not as popular as the other, and lack of demand could cause volatility in the long part of the yield curve.
After European sovereign yields dropped suddenly last week with 10-year Bund yields testing support at -0.10%, today they look once again on the rise. The market has started to price an ECB interest rate hike as early as October. On Thursday, the ECB will release its monetary policy meeting accounts, showing how worried officials are about inflation upside risk, influencing hiking expectations. On the same day, a second reading on euro-area consumer prices will be released, which preliminary data showed to have jumped to 5%.
Sovereign bond issuance continues this week with Germany selling 5-year and 15-year bonds, France selling 3-year, 5-year, and 7-year Notes, Spain selling 5-year, 8-year, and 18-year Bonds.
We expect bidding metrics to remain sustained in European sovereign auctions; however, volatility will remain high amid fading ECB support and higher yields in the US. We expect sovereigns with the highest beta, such as Italy, to be more vulnerable.
Monday, January the 17th
Tuesday, January the 18th
Wednesday, January the 19th
Thursday, January the 20th
Friday, January the 21st
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