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FOMC bond takeaway: beware of ultra-long duration.
Althea Spinozzi
Head of Fixed Income Strategy
Summary:
- Summary of Economic Projections: upward revisions in growth and long-run rates are bearish for long-term Treasuries.
- Quantitative Tightening tapering needs to be implemented before June, as the runoff of T-bills accelerates in summer. The Fed will likely opt for a reverse "operation twist" rather than simple tapering, putting pressure on long-term yields.
- The Fed risks losing its credibility. If inflation continues to surprise to the upside, but the central banks stick with rate cuts, bond vigilantes might return claiming a higher term premium.
- Since the beginning of March, the iShares 20+ year Treasury Bond ETF (TLT) saw the largest outflows since January 2022, showing that investors are preparing for another bullish year for risky assets.
Takeaways for the bond market: beware of long duration.
Yesterday's FOMC meeting was key for bond markets because it strengthened the idea of a soft landing. This is good for risky assets but bearish for bonds carrying high duration because:
- With a higher long-run rate, long-term yields will price over a higher base. Every time there is a recession scare, ten-year yields drop below 4% because bond markets envision the Federal Reserve cutting earlier and faster than expected toward their long-run rate. Considering that historically, 10-year US Treasury yields paid between 100bps to 150bps over the Fed Fund rate, that means that if the Fed sees equilibrium at 2.5%, the 10-year yields should fall between 3.5% to 4%. As the long-run rate rises, an equilibrium for the 10-year year yields moves higher.
- Without a recession, markets will rotate from safe to risky assets. Growth is expected above trend for the next three years, so stocks will become more appetible than bonds as they should provide higher returns. That's bearish for US Treasuries, which carry a long duration.
- Quantitative Tightening tapering targets a more significant reduction in the balance sheet over time. Powell said at the press conference that QT tapering is coming soon, and as we have outlined in preview research, it needs to arrive by June, as from then on, the runoff of T-bills will accelerate weighting on money markets. The Fed is likely looking to do a "reverse operation twist" aimed at disinvesting actively long-term US Treasuries and Mortgage-Backed Securities (MBS) to increase their share in T-Bills. For more on the topic, click here.
We, therefore, continue to favor the front part of the yield curve for up to 5 years. The 10-year tenor offers an appealing risk-reward ratio in a buy-and-hold diversified portfolio, although the yield might rise. We are cautious of the ultra-long part of the yield curve as the macro-economic backdrop calls for a steeper curve and high long-term yields.
Despite the long part of the US Treasury yield curve not reacting, it's important to note that market sentiment is changing fast. Since the beginning of the month, TLT, the iShares 20+ year Treasury Bond ETF, has seen the largest outflow since January 2022.
Key changes to the Summary of Economic Projections:
- Growth was revised upward for 2024-25-26, reinforcing the idea of a soft landing. It's key to note that the Federal Reserve is more sanguine about the economy than markets. Indeed, SEP GDP for this year matches the market consensus of 2.1%, but it exceeds the market consensus for 2025, when the market expects the economy to grow only by 1.7% and the SEP by 2%.
- The labor market is expected to remain strong. Unemployment was revised downward for 2024-25-25, matching economists’ consensus, and expected to never rise above 4.2%
- Inflation will remain sticky for longer. Core PCE was revised upwards from 2.4% to 2.6% for 2024, exceeding market expectations.
- The dot plot shows one less rate cut in 2025-26 and a higher long-run rate. Interestingly, even if growth and core PCE are expected to remain elevated, the Fed is still looking to cut rates three times this year.
FOMC press conference: focus on quantitative tightening.
The Fed press conference was notably dovish, with Powell dismissing the upside surprise in inflation for January and February and highlighting that labor market weakening could warrant a policy response. Powell also mentioned that a decision about QT will be made soon, which might imply a greater balance sheet reduction over time. For our take on it, click here.
The bond market reacted with a twist, steepening the yield curve. Two-year yields dropped by -8bps, closing the day at 4.6%, ten-year yields dropped by -2bps to 4.37%, but 30-year yields closed the day 2.5bps higher at 4.45%. We expect the twist steepening to continue in the next few weeks.
Other recent Fixed Income articles:
18-Mar Bank of England Preview: slight dovish shift in the MPC amid disinflationary trends.18-Mar FOMC Preview: dot plot and quantitative tightening in focus.
12-Mar US Treasury auctions on the back of the US CPI might offer critical insights to investors.
07-Mar The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.
05-Mar "Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?
01-Mar The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.
29-Feb ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.