Fixed income market: the week ahead

Will US Treasury yields continue to rise?

That’s the question on everybody’s mind as we are approaching a critical nonfarm payroll on Friday. Last month's jobs miss lead doves to believe that the Fed would postpone tapering further down the line, as their maximum employment target has not been met yet. However, we believe that is just wishful thinking. Indeed, jobs continue to recover while there is no sign yet that inflation is as transitory as the Fed wants us to believe. That makes inflation the primary driver of monetary policies since sustained price pressures will need to be met with unexpected aggressive monetary policies.

There is more potential for jobs to surprise on the upside than to the downside in September, pushing the market to consider an aggressive rate hike path. On one side, jobs openings are at record-high levels. On the other, unemployment benefits expired at the beginning of September, forcing lower-paid labour to return to work. However, to put a strain on the jobs recovery might be the debt ceiling dilemma as budget uncertainties and a potential upcoming government shutdown led to a slower recovery of jobs in the public sector compared to the private sector.

A strong jobs report will definitively weigh on the bond market leading to higher yields in the belly of the curve, but a weak jobs report might not equally lead to lower yields as it’s becoming clear that more aggressive monetary policies will be unavoidable going forward. Doves often point to a slowdown in growth as one of the reasons for the FED to keep dovish. Yet, growth is not contracting: it’s decelerating from extremely high levels brought by the reopening of the economy and base effects. Therefore, it's unlikely that the Fed's tapering agenda will halt in light of slower but sustained growth.

Another question that investors will ask themselves is whether we will see a steepening or a flattening of the yield curve.

Indeed, in the past few days, we have seen the yield curve steepening substantially, with the 2s10s spread widening to 120bps and the 5s30s spread widening to 111bps after plunging below 100bps in the wake of the latest Fed decision. However, the yield curve remains flat compared to the beginning of the year. That is a problem for the Federal Reserve because in case it needs to hike interest rates earlier, it would require the yield curve to be steeper to rule out the risk of curve inversion.

During the last FOMC meeting, the message surrounding rate hikes was bleak. The Eurodollar strip began to price more aggressive monetary policies already starting by this year, considering a 15bps rate hike by December. The potential for early interest rates hikes remain elevated and adds to the risk of a bear flattening with the belly of the curve rising fast and long term yields dropping signaling a Fed’s policy mistake ahead, especially if the market remains preoccupied about slower growth. If the market accepts that slower but sustained growth is no risk, we should see the yield curve steepening instead of bear flattening.

Lastly, debt ceiling talks are becoming more and more important for money markets. On Friday, the yields on T-Bills with maturity at the end of October and the beginning of November doubled in yield. This morning T-Bills with maturity November the 2^nd offer 11bps, more than double of the RRP facility. As debt ceiling talks continue without finding a resolution, we can expect more volatility in money markets leading to a bead flattening of the yield curve, which would drag long term maturity lower as they will be seen as a safe haven.

Regarding the supply of US Treasuries, there are no significant auctions this week. Still, next week the Treasury will sell long maturity, which might contribute to bearish sentiment to the longer part of the yield curve.