Head of Fixed Income Strategy
Summary: We believe that the Federal Reserve will stick to its hiking plan or become even more aggressive as the economy remains strong, but elevated inflation pressures persist. Therefore, there continues to be space for the US yield curve to bear-flatten. Although 2-year yields are currently pricing rate hikes for the whole year, they could continue to soar to 2.5% as the Federal Reserve maintains hawkish. Within this context, long-term yields are unlikely to drop until there are clear signs of stagnation. Things could change during the second half of the year if the probabilities of a contraction rise.
Although it's challenging to forecast the economic outlook due to the evolving situation in Ukraine, it’s fair to assume that the Fed will stick to its hiking plan to fight inflation. Suppose the central bank is concerned about a slowdown in growth. In that case, it will look to front-load interest rate hikes this year as the economy remains strong and the choice to fight inflation remains popular. Therefore, it’s safe to expect the yield curve to continue to bear-flatten.
Since last week, two-year US Treasury yields have been testing strong resistance at 2%, a level previously seen in May 2019, when the Fed fund rate was 2.5%. The Fed is looking to bring the benchmark rate at 2% by the end of the year and 2.75% in 2023. Suppose markets deem this hiking path to be realistic. In that case, there is definitively room for 2-year US Treasury yields to begin to price rate hikes for 2023 throughout the year. Yet, rate hikes for this year have already largely been priced in the front part of the yield curve. Therefore, two scenarios are possible: either growth remains sustained throughout the year, giving the green light to the Fed to hike rates as planned, or growth will get seriously hit in the second half of the year, forcing the market to reconsider rate hikes for 2023. We would probably see 2-year yields moving towards 2.5% in the first scenario. In the second scenario, the front part of the yield curve would remain around the values we see today.
We believe that there is a bigger chance of seeing 2-year yields breaking above 2% in the short term and remaining sustained above this level until summer as the central bank's language has become hawkish. However, as the macroeconomic outlook becomes clearer, there are chances that the market begins fearing a recession. In that case, 2-year yields would remain around the levels we are currently seeing.
Similarly, we don't believe that long-term yields will plummet unless there are clear signs of stagnation, which might not surface until the year's second half.
This week's focus is on the Fed officials' speeches, starting today with Powell commenting on the economic outlook at the National Association for Business Economics annual conference. Powell will also speak on Wednesday in front of the Bank for International Settlements. We'll also hear from Williams, Daly, Mester, Kashkari, Waller, and Evans
throughout the week.
The 2-year and 20-year US Treasury bond auctions on Wednesday will also be in focus. It will be critical to see how investors position in the short-term versus the long-term of the yield curve in light of last week's FOMC meeting.
In Europe, the focus will be on the PMI data and ECB officials speaking. Lagarde is speaking today and tomorrow.
Although Russia avoided defaulting on its own debt last week, it's a matter of time before we see defaults rising in that part of the world. Sadly, the Ukrainian poultry, grain, and meat producer MHP is the first Ukrainian company to default on its US dollar debt due to the war.
In Venezuela, government and PDVSA bonds have jumped from 6 to 10 cents on the dollar as investors speculate on a US deal.
Monday, March the 21st
Tuesday, March the 22nd
Wednesday, March the 23rd
Thursday, March the 24th
Friday, March the 25th
Quarterly Outlook
Chief Investment Strategist
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Head of Fixed Income Strategy
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