Global Head of Fixed Income Strategy
March 12, 2017
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While long-dated yields seem unlikely to rise significantly from here, short rates remain under pressure.
President Trump’s joint address to Congress on 28 February reminded markets of his big spending promises, including tax reform and a $1 trillion infrastructure program. This helped bring long-term US Treasury (UST) rates back toward the highs for the year. Still, uncertainties over the size and timing of these promises – as well as other foreign political risks – have essentially kept long-dated UST yields range-bound since last November’s US elections. Our base-case view remains that US tax cuts –corporate and individual – and regulatory actions will boost growth and inflation, with Treasury yields moving higher. However, we reiterate that, without any confirmation of actual policy, it is unlikely long-dated yields can rise meaningfully from current levels.
On the other hand, short-term US rates are likely to remain under pressure. Following a series of hawkish FOMC member speeches (including Fed Chair Yellen), Fed Futures have significantly repriced and now imply a 100% probability for a rate hike on March 15, up from 25% last month. This has fueled the UST yield curve to flatten, with 2-year yields reaching their highest levels since June 2009. In our view, we expect this dynamic to persist as markets discount additional rate hikes later this year.
Three-month LIBOR has now reached 1.1%, a rise of 50bp over the last 12 months. Though the impacts on US dollar funding from money-market reforms are now behind us, LIBOR is expected to rise further, along with higher Fed Funds. Citi economists project 3-month LIBOR to reach 1.5% by the end of 2017, though risks are building which could push levels even higher. As such, we continue to recommend hedging floating-rate liabilities.
In normal US economic cycles, stronger growth and higher inflation typically translates to a steeper UST yield curve, followed by tighter Fed policy. Today, tighter policy is occurring while growth and inflation prospects are improving. Though the curve has steepened some over the last 6 months, the removal of monetary accommodation should detract from potential growth, pushing the curve flatter over time. Similar to how the US yield curve has behaved in every tightening cycle in our history.
This does not mean certain parts of the UST curve can’t move independently to this view. For example, since last August the difference between 2-year and 10-year Treasury yields widened (or steepened), as potential Trump policies provoked markets to discount higher inflation. On the other hand, the spread between 10 and 30-year Treasury yields narrowed (or flattened), as political risks and foreign demand kept long-rates relatively well-bid. These divergent reactions can create tactical opportunities. Indeed, long-end steepeners could benefit from any follow through on the possible issuance of ultra-long term US debt.
Among inflation-linked securities, ten-year US TIPS (Treasury Inflation Protected Securities) breakeven spreads have largely moved sideways since eclipsing 200 basis points last December. Still, TIPS have outperformed UST by 75bp year-to-date as headline CPI continues to rise. We expect headline inflation to rise further in coming months, as base-effects from rising oil prices peak. Though TIPS valuations appear fully valued, breakevens could widen more and we’d expect further outperformance versus nominal UST. Though base-effects should fade, we also like TIPS as a hedge against potential US trade disruption. In some scenarios, trade disruption could result in higher domestic inflation and lower growth.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.