Head - Fixed Income Strategy
March 9, 2018
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Though concerns over US rates remain relevant, risks appear more balanced.
Strengthening inflation data, expected deficit widening, increased Treasury (UST) supply, higher oil prices and relatively hawkish US Fed chairman comments to Congress, make up a bearish checklist.
These factors have played a role in watching 10-year UST yields reach 2.95% last month, its highest level since January 2014 (currently 2.85%). At the same time, short-term rates continue to reach new post-crisis highs, with 2-year UST yields rising 20bp in February to 2.25%. Consequently, this has pushed the yield curve flatter, bringing the difference between 2-year and 10-year UST yields back toward 60bp (2s10s had widened to 78bp in mid-February).
On February 26, the new Fed Chairman Jerome Powell spoke to US Congress in his first semi-annual monetary policy report to Congress (previously known as the Humphrey-Hawkins reports). His overall positive assessment over the US economy and the Fed’s inflation targets, helped raise market expectations over future tightening. With three rate hikes for 2018 now being fully priced in, futures markets have now begun to price in small chance of a fourth hike.
More importantly, markets are still underpricing the Fed for 2019. Considering our expectation for 3 hikes in 2018, and 3 more in 2019, higher short rates and a flatter yield curve remains our base-case over the next 12-18 months. Indeed, 3-month LIBOR has now breached 2.0% and expected to rise above 2.5% by year-end.
Though concerns over higher long-term rates remain relevant, and a push toward 3.0% isn’t negligible, risks do appear more balanced. However, speculative positioning is not. Indeed, net positions of long-dated UST futures by speculative investors (i.e. hedge funds) remain near historically low levels.
Shifts in sentiment or market uncertainty can provoke the movement of fast money, exacerbating price swings. For example, if we consider the rising tensions over US/China trade announcements, any further escalation of protectionism may spur risk-off sentiment. This could provoke short covering by speculative investors, pressing long-term rates lower.
Other bullish factors to consider: One, with yields rising 90bp since September 2016, 10-year US Treasury’s are now the 4th highest yielding developed sovereign market in the world.
Two, the rise in UST yields has not been matched by rising yields in other core markets. As such, the yield difference between the US and core has widened back near historical wide levels. The yield difference between 10yr UST and 10yr German Bunds is now 220bp.
Three, higher nominal yields and wider differentials has translated into increased demand from foreign officials (i.e. central banks). Higher demand may offset the increase in UST supply.
Four, with crude oil prices rising 30% over the last 6-months, the noticeable increase in production may provoke profit-taking. Lower oil prices would likely push inflation expectations lower, and long with nominal rates.
Five, February’s US employment report suggests upward wage pressures are not overly concerning. Though inflation is expected to move higher this year, anxieties over a faster pace should be moderated and limit the move higher in long-term rates.
Rate volatility has also remained relatively elevated, with the Merrill Lynch Option Volatility Estimate Index (or MOVE index) spiking to 71bp. While still well below more recent spikes, higher levels of rate volatility are likely to persist.
With spikes in volatility likely to become more frequent, hedging strategies or ways to protect downside risk in fixed income portfolios should be considered.
Worth watching: The FOMC (Federal Open Market Committee) is expected to convene on March 21, where the committee plans to release an update to their economic projections. Markets will likely be focused on the “dot plot” to see if FOMC members have become more optimistic on the number of rate hikes in 2018, or beyond. In our view, for the median to shift from three hikes to four in 2018, it would take five FOMC members with centrist projections to increase their rate expectations. This is unlikely. Still, any subtle shift higher by some members will likely be scrutinized and have an influence on short-term rates.