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More Fed tightening to come

Kris Xippolitos

By Kris Xippolitos

Head - Fixed Income Strategy

June 12, 2018Posted InInvestments, Fixed Income and Investment Strategy

Long-term UST rates remain the litmus test of global investor risk appetite. Encouraged by the possibility of trade deals and positive US/North Korean dialogue, markets last month were able to refocus on improving US fundamentals, rising Treasury supply and a 20% surge in oil prices (January through May). This helped push equities higher and bond prices down, with 10-year UST yields reaching a seven-year high of 3.12%.

Markets then seemed to wake up from a proverbial dream, as the US announced they were moving ahead with tariffs on aluminum and steel imports from Canada, Mexico and the European Union, as well as proceeding with tariffs on $50 billion in Chinese imports. However, the eruption in Italian politics took markets by surprise, as fears were renewed over the long-term stability of the Eurozone. Altogether, this quickly changed investor sentiment, driving flight to quality flows, short-covering and sending 10-year UST yields back down to 2.75%.

Markets have since calmed, though long-dated yields currently remain below 3.0%. Numerous political and policy issues have weakened investor confidence, leaving markets susceptible to over-reaction and contagion. Though the dire near term outlook in Italy may have been thwarted by the formation of a government, geopolitics will likely continue to be a periodic driver of safe haven flows for months to come.

While creating a tactical trading paradise, longer-term investors may find it difficult taking outsized duration bets. Growing UST supply to fund a widening deficit will remain an overhang for the next several years, while rising hedging costs has reduced the relative value of US fixed income for certain types of hedged investors. For example, European investors who hedge an investment in 10-year UST would end up with a yield less than 10-year German Bunds – figure 1.

Figure 1. Hedged euro investors benefit less in UST yields

Source: Bloomberg as of June 7, 2018.

Past performance is no guarantee of future events. Real results may vary. 

Alternatively, US yield differentials versus other markets continues to grow. Currently, 5-year UST yields at 2.75% are higher than almost every other developed market (DM) 10-year bond – figure 2. Demand at recent auctions have also been above average, with increasing participation from central banks. For example, the most recent $22 billion reopening of 10-year notes drew its largest share from direct bidders (typically asset managers) since 2015. That said, the overall balance of risks appears fairly distributed, and we continue to favor a neutral duration view.

Figure 2. 5 yr UST yields more than most other 10yr bonds

Source: Haver Analytics as of June 7, 2018.

Past performance is no guarantee of future events. Real results may vary.

Federal Reserve update: The improving US fundamental outlook is likely to keep the Federal Reserve in tightening mode. The unemployment rate has reached its lowest level since 1969, as other macro factors continue to track real GDP 2Q growth around 3.0%. Signs of firming wage growth is encouraging, however, the pace of inflation is expected to remain relatively modest and unlikely to move meaningfully beyond the Fed’s 2.0% mandate.

As such, we expect the Federal Open Market Committee (FOMC) to raise the Fed Funds (FF) rate 25bp to 2.0% on June 13. Our base case view is for an additional rate hike later this year, with three more 25bp hikes in 2019, bringing the upper-bound of the Fed Funds rate to 3.0%. Though it’s possible for the Fed to raise rates once per quarter, we view this particular path as somewhat more challenging, especially amid a number of political and policy issues around the world. Considering our base-case for higher short-rates and range-bound longer-term yields, we maintain our bias for a flatter UST yield curve.


LIBOR update: 3-month LIBOR (3ML) has been relatively stable for the last two months around 2.3%, coinciding with the moderation in T-Bill supply. The possible realignment of the Fed’s use of interest on excess reserves (IOER), relative to the FF target range could moderate the upward pace of LIBOR. Indeed, the Fed minutes for May showed the Fed’s consideration to set IOER below the FF upper bound. This could increase the competitiveness of short-term alternatives, and lessen the demand for LIBOR-based funding. Indeed, the spread between 3ML and FF has already moderated. That said, though we expect Fed tightening to push up LIBOR rates over the next 12-18 months, the impending rate hike may not have much near-term impact.

Fixed income investments are subject to credit and interest rate risk. As interest rates rise, the price of fixed income securities falls. Credit risk, which is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt.