Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Access both platforms from your single Saxo account.
Two-year US Treasury notes offer an appealing entry point.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Sticky consumer and producer prices, a resilient job market, and solid PMI readings are not putting pressure on the Federal Reserve to begin cutting rates. At the same time, the FOMC minutes indicate that the tapering of the Quantitative Tightening is imminent, and it will be discussed in March, ahead of the US Treasury issuing pandemic-like levels of coupon notes and bonds in the second quarter of the year. The recent rise in yields in the front part of the yield curve offers an appealing entry point for investors, as current valuations match the Dot Plot with expectations of three interest rate cuts for this year. However, we remain cautious and see the risk of a bear-steepening of the yield curve triggered by sticky inflation and the issuance of pandemic-like amounts of notes and bonds.
The FOMC minutes show that the tapering of Quantitative Tightening is imminent.
We have learned from the FOMC minutes that policymakers are willing to hold current rates for longer but are starting to worry about systemic liquidity. The minutes say, "In light of ongoing reductions in usage of the ON RRP facility, many participants suggested that it would be appropriate to begin in-depth discussions of balance sheet issues at the Committee's next meeting to guide an eventual decision to slow the pace of runoff. Some participants remarked that, given the uncertainty surrounding estimates of the ample reserve level, slowing the runoff pace could help smooth the transition to that level of reserves or could allow the Committee to continue balance sheet runoff for longer.”
To be clear, bank reserves are ample and exceed $4 trillion. Yet, once that Overnight Reverse Repurchase (ON RRP) facility, which currently amounts to a little over $500 billion, is drained, US reserve balances with the Federal Reserve banks will begin to be depleted. That's when liquidity might start to become stretched, warranting a slower pace of runoff to avoid a liquidity event such as the one in 2019.
An announcement regarding Quantitative Tightening (QT) is likely to come as soon as March because the US Treasury is preparing to issue pandemic-like levels of coupon bonds. If the Federal Reserve doesn't slow down QT, further pressure will be applied on US Treasuries, causing further tightening of financial conditions. Remember that the Bank Term Funding Program (BTFP) is ending in March, and bank liquidity is being withdrawn.
Based on the latest Treasury Borrowing Advisory Committee Advisory (TBAC) recommendations, coupon issuance might rise by $33 billion in Q2. The pace of balance sheet runoff is currently capped at $60 billion a month. Therefore, it’s enough for the Fed to taper QT by $11bn a month to not add pressure in bond markets.
There is no love for duration.
The recent 20-year US Treasury and 30-year TIPS auctions show weak demand for ultra-long maturities. The 20-year US Treasury auction saw a significant drop in indirect bidders to 59.1%, the lowest since May 2021. The bid-to-cover price has also dropped to the lowest since August 2022, resulting in a 3.3bps tail. The day after, the 30-year TIPS auction also tailed by 2.5bp despite paying 2.2% in yield, the highest since 2010. Demand for TIPS was much more solid than the 20-year bonds, showing that investors are still buying inflation protection but demand higher returns in light of uncertainties concerning price pressures.
With the US Treasury looking to sell $1 trillion coupon notes and bonds in the second quarter of the year, we expect ultra-long US Treasury auctions to be the cause of volatility, contributing to a rise in yields in the long part of the yield curve. We remain cautious and don't see scope to add duration beyond the ten years as explained here.
Expectations for interest rate cuts are now matching the Dot Plot.
Sticky consumer and producer prices, a resilient job market, and solid PMI readings have provoked a bear-flattening of the US yield curve. Two-year US Treasury yields (US91282CJV46) rose from 4.11% in January to 4.73% today. Such a move offers an appealing entry point for investors, as current valuations match the Fed dot plot expectations of three interest rate cuts for this year. For two-year US Treasury yields to rise further, inflation must remain sticky in the high 2% or rebound, forcing the Fed to push back on rate cuts. Even if that happens, the 2-year US Treasury offers an appealing risk-reward ratio even when assuming a short-term holding period. Assuming a three-month holding period, yields need to rise by more than 100bps to provide a loss. If the holding period increases to six months, yields need to rise to 6.75% before giving a negative total return. For yields to rise that much in such a short time frame, inflation needs to rebound substantially, forcing the Federal Reserve to hike the Fed Fund rate four more times in only six months, which, at the moment, looks extremely unlikely to happen.
Latest Market Insights
Quarterly Outlook
-
-
Quarterly Outlook
Equity Outlook: Will lower rates lift all boats in equities?
Peter Garnry
Chief Investment Strategist
After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto... -
Quarterly Outlook
FX Outlook: USD in limbo amid political and policy jitters
Charu Chanana
Chief Investment Strategist
As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ... -
Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c... -
Quarterly Outlook
Commodity Outlook: Gold and silver continue to shine bright
Ole Hansen
Head of Commodity Strategy
-
Quarterly Outlook
FX: Risk-on currencies to surge against havens
Charu Chanana
Chief Investment Strategist
Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo... -
Quarterly Outlook
Equities: Are we blowing bubbles again
Peter Garnry
Chief Investment Strategist
Explore key trends and opportunities in European equities and electrification theme as market dynami... -
Quarterly Outlook
Macro: Sandcastle economics
Peter Garnry
Chief Investment Strategist
Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p... -
Quarterly Outlook
Bonds: What to do until inflation stabilises
Althea Spinozzi
Head of Fixed Income Strategy
Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ... -
Quarterly Outlook
Commodities: Energy and grains in focus as metals pause
Ole Hansen
Head of Commodity Strategy
Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)