Head - Fixed Income Strategy
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US rates rely on future tax reforms progress and Fed rate hikes
The pendulum has shifted yet again, as US Treasury (UST) yields react to rising expectations for future Fed rate hikes and renewed optimism over tax reform. After nearly reaching 2.0% in early September, amid geo-political concerns and summertime illiquidity, 10-year UST yields have since risen 30 basis points (bp) back toward 2.4%.
However, the shape of the yield curve is relatively unchanged, as 2-year yields reach higher post-crisis highs (currently 1.50%). Indeed, the increase in short-rates has flattened the curve all year, with the difference between 2 and 30 year UST yields narrowing 50bp to 140bp.
As we look into year-end, the direction of UST rates will rest largely on any progress over US tax reform and Fed committee member nominations. The probabilities of some modest fiscal easing are higher in our view than markets believe. Indeed, futures positioning (according to Commitments of Traders data) imply speculative investors are comfortable with long duration exposures. Though unlikely to occur quickly, any advancement on taxes will reignite reflation trades and higher long-term yields. Conversely, without the anticipation of fiscal easing, the sell-off in long-rates should fade.
With President Trump announcing his intention to nominate a Fed chair in the coming weeks, a number of candidates are being debated. Markets have not yet seemed to anoint any clear-cut candidate, as Chairwoman Yellen appears just as likely to be re-nominated for a second term, as other more hawkish choices. With Vice Chair Stanley Fischer resigning, and several other Board of Governor seats still vacant, risks of a hawkish tilt are not negligible.
On September 20, it was widely anticipated that the Federal Reserve would leave policy rates unchanged at 1.00 - 1.25%. More notably, the Fed kept its median projection for the fed funds rate at 1.4% for year-end 2017, implying an additional 25 basis point tightening by December. This resulted in a significant repricing of market implied expectations, as probabilities for a December rate hike soared above 75% from 30%. LIBOR rates also reacted, with 3-month US dollar funding rates reaching a post-crisis high of 1.35%.
While the gap between market expectations and Fed projections has narrowed for the December meeting, investors continue to significantly underprice future rate hikes. Indeed, while Fed projections call for three more rate hikes in 2018 (as do Citi economists), Treasury futures imply we may only see one more. As long as lower inflation trends do not become problematic, we believe the Fed should continue on their slow path toward higher policy rates. In turn, markets would need to adjust expectations, pushing short-term yields higher and yield curves flatter. We continue to recommend investors hedge floating-rate liabilities or allocate toward assets which would benefit from rising short-term rates.
We do recognize that current market positioning can create short-term reversals of certain trades that have performed well this year. This includes a weaker US dollar and the flatter yield curve. If we get agreements on tax policy and/or markets increase their expectations for future rate hikes, the yield curve could steepen in response. That said, similar to the curve reaction post US election last year, any counter-trend move to a steeper yield curve should ultimately reverse. As we’ve repeatedly mentioned, the US yield curve has flattened in every single tightening cycle in our history.
Also as expected, the Federal Reserve announced they will begin to taper their $4.5 trillion portfolio of UST, agency debt and agency mortgage-backed security (MBS) portfolio. Set to begin this month, the Fed will allow up to $6 billion a month in maturing Treasuries to run off, raising the cap $6 billion every three months to a maximum of $30 billion. In similar fashion, the central bank will also allow agency debt and agency MBS to run off at a capped pace of $4 billion a month, increasing to a maximum of $20 billion.
As we discussed last month, we think this is modestly bearish for US rates as a greater flow of private investment will be needed to fund government borrowings. However, the slow and transparent decline in the Fed’s balance sheet is not likely to induce any taper tantrum market reaction, in our view.