Six reasons why interest rates will continue to rise in 2022

(2) Federal Reserve: hawkish tilt in 2022

It has arrived the time to care about comments that the Federal Reserve’s ultra-hawks are making.

This week, the president of the St. Louis Fed, James Bullard, urged for more hawkish policies to cool off inflationary pressures. He brought up interesting points, including that early hikes might allow the central bank to hike less, that it is still possible for the central bank to hike rates before tapering ends and that a balance sheet run-off might begin soon after the conclusion of tapering.

His comments didn't go unnoticed, and at the time of his speech, 5-year and 10-year yields rose approximately by 3bps. Yet soon after Bullard’s Bloomberg interview ended, yields dropped, signaling that the above hawkish comments do not make a difference after all.

However, they might soon have more weight as Bullard, and another five notable hawks will be voting members at the FOMC meetings next year. That’s a clear hawkish tilt from the dovish Fed we have witnessed to in 2021.

The implication of such a change is key for the bond market because while the Federal Reserve has been comfortably behind the curve in acknowledging inflation risk until now, next year, it might not.

(3) The macroeconomic backdrop is likely to remain inflationary.

As we pointed out several times throughout this year, there are signs that inflation will stay elevated for quite some time. Investment scarcity in the physical world (energy and mining), supply chain disruptions, sustained demand in the developed world and increase in rents point to higher inflation than the Federal Reserve 2% target throughout 2022. Yet, the big question is whether we are witnessing a structural change that will bring inflation above 2% for much longer. According to many CEOs, it's likely that we see a structural shift in price pressures as salaries have increased substantially, and they aren't expected to be reduced in the near future. Yet, the transitory dilemma becomes somewhat irrelevant for bonds when we are not talking anymore about months of high inflation but years. Even more so, when the economy is still expanding above trend.  Everything is saying that bonds are currently mispriced. Hence, yields need to increase substantially to match the current macroeconomic picture.

Even if one believes that yields will remain stable, it still doesn't make sense to hold US Treasuries at current levels because the downside risk is way bigger than the upside.

(4) Interest rate hikes expectations will need to advance.

As a consequence of the points above, interest rate expectations will need to advance. So far, the market is pricing more than two interest rate hikes by the end of 2022. However, as inflationary pressures continue to increase, the Federal Reserve will grow more aggressive. As that happens, we’ll see the yield curve bear flattening. Long term yields will need to rise, too, although slower than the front part of the curve. 

(5) Demand for US Treasuries is weakening: watch US Treasury auctions.

As the macroeconomic backdrop remains inflationary, demand for US Treasuries decreases due to their deeply negative real yields. We had proof of this during last week’s disastrous 30-year bond sale, which saw the biggest tail on record for this tenor (5.2bps). We were expecting another catastrophic 20-year auction this week, however, policymakers might have just dodged the bullet. Indeed The US Treasury cut the size of the bond sales. At the same time, the Federal reserve kept buying the same amount of bonds with maturity between 10-years and 22.5-years despite beginning with tapering purchases under their QE program.

The modest tail of 1.4bps during the 20-year bond sale was enough to attract demand from investors trading this tenor in a 10s/20s/30s butterfly, which cheapened considerably after last week’s selloff.

Yet, we expect demand for US Treasuries to wane as tapering advances paving the way for higher yields also on the long part of the yield curve.

(6) Debt ceiling: might continue to cause volatility in money markets.

We have to consider one last thing in our analysis: the debt limit crisis and how it affects the yield curve. Recently, Janet Yellen said that the US Treasury cash wouldn't last long past the 3^rd of December. The money market reacted with yields of T-Bills maturing at the end of the year rising above the Fed's Reverse Repurchase rate. The debt ceiling crisis also has implications for the long part of the yield curve. If volatility increases in money markets, it's likely that the 10-year US Treasury will serve as a safe haven compressing yields on the long part of the yield curve.

Yet, it's essential to acknowledge that this problem has to be tackled by the end of this year. Once resolved, the pressure capping long-term yields is removed, leaving rates free to rise next year.