FOMC bond takeaway: beware of ultra-long duration.

Summary:

• Summary of Economic Projections: upward revisions in growth and long-run rates are bearish for long-term Treasuries.
• Quantitative Tightening tapering needs to be implemented before June, as the runoff of T-bills accelerates in summer. The Fed will likely opt for a reverse "operation twist" rather than simple tapering, putting pressure on long-term yields.
• The Fed risks losing its credibility. If inflation continues to surprise to the upside, but the central banks stick with rate cuts, bond vigilantes might return claiming a higher term premium.
• Since the beginning of March, the iShares 20+ year Treasury Bond ETF (TLT) saw the largest outflows since January 2022, showing that investors are preparing for another bullish year for risky assets.

Takeaways for the bond market: beware of long duration.

Yesterday's FOMC meeting was key for bond markets because it strengthened the idea of a soft landing. This is good for risky assets but bearish for bonds carrying high duration because:

1. With a higher long-run rate, long-term yields will price over a higher base. Every time there is a recession scare, ten-year yields drop below 4% because bond markets envision the Federal Reserve cutting earlier and faster than expected toward their long-run rate. Considering that historically, 10-year US Treasury yields paid between 100bps to 150bps over the Fed Fund rate, that means that if the Fed sees equilibrium at 2.5%, the 10-year yields should fall between 3.5% to 4%. As the long-run rate rises, an equilibrium for the 10-year year yields moves higher.
2. Without a recession, markets will rotate from safe to risky assets. Growth is expected above trend for the next three years, so stocks will become more appetible than bonds as they should provide higher returns. That's bearish for US Treasuries, which carry a long duration.
3. Quantitative Tightening tapering targets a more significant reduction in the balance sheet over time. Powell said at the press conference that QT tapering is coming soon, and as we have outlined in preview research, it needs to arrive by June, as from then on, the runoff of T-bills will accelerate weighting on money markets. The Fed is likely looking to do a "reverse operation twist" aimed at disinvesting actively long-term US Treasuries and Mortgage-Backed Securities (MBS) to increase their share in T-Bills. For more on the topic, click here.

We, therefore, continue to favor the front part of the yield curve for up to 5 years. The 10-year tenor offers an appealing risk-reward ratio in a buy-and-hold diversified portfolio, although the yield might rise. We are cautious of the ultra-long part of the yield curve as the macro-economic backdrop calls for a steeper curve and high long-term yields.

Despite the long part of the US Treasury yield curve not reacting, it's important to note that market sentiment is changing fast. Since the beginning of the month, TLT, the iShares 20+ year Treasury Bond ETF, has seen the largest outflow since January 2022.