Head of Fixed Income Strategy
Summary: Dovish Federal Reserve members’ speeches trump a weak 7-year auction as the market believes inflation is over. Waller's remarks suggest Fed members’ focus is gradually shifting from inflation to growth, building the case for a bull-steepening of the yield curve. However, challenges remain as fiscal pressures imply larger coupon issuances next year. The divergence in the forward outlooks of the dot plot and bond futures brings into focus the December Fed meeting and a new dot plot.
Yesterday's Waller speech gave markets confirmation that the Federal Reserve might not be, after all, putting inflation at the forefront of its monetary policy decisions. Indeed, he affirmed that rate cuts might occur much earlier than the 2% inflation target has been achieved:
Fed governor Chris Waller said that if inflation cools “for several more months — I don’t know how long that might be — three months, four months, five months — that we feel confident that inflation is really down and on its way, you could then start lowering the policy rate just because inflation is lower.”
That opens the way for a bull-steepening of the yield curve because the next most likely Fed's rate move is a cut rather than a hike.
Surprisingly, a soft 7-year auction tailing 2.1bps amid a bond rally, with primary dealers being awarded 20.3%, the highest in a year, did little to deter bond bulls despite fiscal pressures.
Consequently, the yield curve bull-steepened with the 2s10s spread ending 10bps wider by the end of the day.
As my colleague Kim explains, the yield on the 10-year US Treasury broke below the key support level at 4.36%, and the RSI closed below 40. There is now downside risk to support at around 4.07%. For 10-year yields to reverse to an uptrend, they must close above 4.52%.
The Bloomberg US Treasury aggregate index shows that treasuries are up roughly 3.4% in November, the most since August 2019, when the Federal Reserve made a U-turn on quantitative tightening (QT) and cut interest rates. Before that, Treasuries rose by 3.4% in 2008 during the month of December amid the global financial crisis.
What's different today from 2008 and 2019 is that the performance of treasuries is merely driven by speculation. Markets are betting that inflation will revert to 2% and that the Federal Reserve will cut rates aggressively. If this doesn't happen, that could be a setback for US Treasuries.
Bond futures are now pricing slightly more than four rate cuts by the end of 2024 and three in 2025. These expectations are in contrast to what the latest dot plot shows. The median of FOMC members sees only two rates cut for 2024 and nearly five for 2025. If FOMC rate cut expectations move from 2025 to 2024, it will further the case for a steeper yield curve and lower yields.
Before that, PCE data tomorrow are in focus, and lower-than-expected inflation figures could also add to the current bullish sentiment of bonds.
Although this might be the beginning of a bond bull market ahead, it's crucial to recognize that challenges remain:
However, as we have seen yesterday, a weak 7-year auction was trumped by dovish Fed talks. Therefore, duration will likely continue to outperform as long as inflation gets to comfortable levels and the economy cools.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
