The good (central banks), the bad (inflation) and the ugly (tapering)

Why are US Treasuries trading within a tight range?

US treasuries have been trading in a tight range between 1.50% and 1.70% because macro data are increasingly mixed. While it is clear that bottlenecks and the reopening of the economy are increasing inflationary pressures, the lack of workers and a slow down in consumer confidence have the potential to hold back the recovery. This scenario pushes back on expectations that the Federal Reserve will begin tapering purchases earlier than expected, keeping yields trapped within this tight range.

What can be the catalyst for US Treasury yields to break above or below this range?

(1) Inflation. In our opinion, there is more probability for the 10-year US Treasury yields breaking above 1.75% and rise above 2% as inflationary pressures increase than for yields to fall. The preliminary data of the University of Michigan survey show that 65% of respondents see inflation above 3% during the next year. Expectations for the next five year remain high, with 55% of respondents seeing inflation solidly above 3%. The bond market prices over inflation expectations rather than hard inflation numbers. Therefore, tomorrow’s PCE figures and final data from the University of Michigan survey may be key to push the breakeven rates higher.

(2) Tapering. Tapering fears will drive US Treasury yields higher and slow down inflation expectations by pushing yields higher. This is what we saw last week when breakeven rates fell from the multiple-year highs amid the release of the FOMC minutes, which showed members’ willingness to discuss tapering in the following meetings. Tapering is indeed a form for the Federal Reserve to tighten financial conditions by injecting less money into the market. In a recent analysis, Credit Suisse money market guru Zoltan Pozsar recently highlighted that if the Fed announced tapering and lifted Wells Fargo's asset growth ban simultaneously, the system will benefit from extra US Treasuries demand. Although it is a valid point, it much depends on how much inflation will rise. The preliminary data of the University of Michigan survey show that 43% of respondents believe inflation will rise above 5% during the next year. If that were the case, tapering might not successfully contain inflation, and the central bank might also need to hike interest rates.

Tapering talks in Europe are irrelevant unless they take place in the US first. Indeed, the old continent's economy is lagging behind the US recovery. Therefore, seeing the ECB talking about tapering before the Fed would be premature. It doesn't mean that European sovereigns are going to immune to tapering talks. Tapering more than inflation will be a topic that moves bond markets on both sides of the Atlantic because it brings reminiscences of the infamous 2013 "Taper Tantrum”.

(3) Endogenous factor. There can be several endogenous factors that can push yields lower. Although it's difficult for us to envision this scenario, it is important to recognize that if ten-year yields break below 1.5%, we will find support next at 1.2%. One of these endogenous factors could be a massive selloff in the stock market that would provoke a flight to safety and a dovish response by Fed pushing yields lower.