Head - Fixed Income Strategy
May 9, 2018
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We outline a number of influences likely to affect the level of long-term UST yields
The 8-month rise in long-term US rates reached a meaningful level last month, with 10-year UST yields breaching 3.0% for the first time since 2014. Hitting an intra-day high of 3.03%, this culminated a 100 basis point move which began in September 2017. So where do we go from here?
In our view, there are a number of influences which are likely to push and pull on the level of long term UST yields over the coming year. However, the recent acknowledgement by the Federal Reserve that inflation is no longer running below target, implies to us that we’ve reached a new higher range on long-term UST yields.
Risks to higher 10-year yields – One: Net supply of UST debt will likely rise further, in order to fund a widening fiscal deficit. Citi economists expect net supply to rise over $1.0 trillion this year, and will likely rise even more in 2019. Indeed, the deficit is expected to widen by an additional $150 billion next year, according to the CBO (Congressional Budget Office).
Two: Inflation is trending higher, and has nearly reached the Fed’s 2.0% target on core PCE (personal consumption expenditures). Signs of building wage pressures could have bearish implications on inflation expectations.
Three: Expected tapering of bond purchases by the European Central Bank (ECB) should be announced later this year, pushing up available net supply. Any cheapening in Eurozone rates could have a pass-through effect on UST.
Four: The significant rise in US dollar hedging costs has diminished the yield pick in UST for certain foreign investors, lessening demand.
Risks to stable/lower 10-year yields – One: The larger majority of expected new UST supply will be issued < 5-years. Excluding weekly T-Bill issuance, 65% of YTD Treasury supply has been placed within five years to maturity. With continued participation from pension funds, auctions for longer tenors will likely be met with sufficient demand. Moreover, ultra-long issuance appears to be off the table.
Two: Citi economists don’t expect core inflation to accelerate far beyond the Fed’s 2% mandate.
Three: Despite a likely ECB bond taper, reinvestments will continue to provide ample technical support. Any shift in reinvestments toward long-dated euro bonds may limit the rise in local yields.
Four: For unhedged investors, 10-year UST at 3.0% is attractive and the third highest yielding developed market in the world.
Five: Commitment of Traders data shows speculative investors are historically bearish. Signs of wavering economic data or a deterioration in financial conditions could push yields lower, as positions reverse.
Despite the market’s inability to break 3.05% on 10-year UST (an important long-term technical level), the aforementioned balance of risks keeps us from taking a strong duration view (we remain neutral).
Also, US/China trade negotiations are likely to remain a catalyst for flight to quality UST flows. We also consider that tariffs on foreign imports may pass through to higher domestic inflation, potentially accelerating the pace of Fed rate hikes.
Though US TIPS breakeven spreads do not offer value at current levels, investors looking to hedge rising domestic inflation or a further increase in commodity prices, may consider inflation linked debt over nominal UST.