Fixed income

US bonds: bridging the gap

07 February 2022

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

The uncertainty over the upcoming policy rate path and a shift in the supply/demand balance in the US Treasury markets seems as high as ever. Pricing suggests that ignoring the noise and focusing on medium-term bonds seems a prudent strategy.

You’ll find a short briefing below. To read the full article, please select the ‘full article’ tab.

  • Summary
    • With the US Federal Reserve taking inflation more seriously, we now anticipate three or four interest rate hikes this year – with the first one coming in March
    • Following the US central bank’s decision in December to wind down pandemic support and get itself in a position to tackle inflation, the Fed has been faced with a rapidly flattening yield curve, inflation expectations dropping like a stone, and the 10-year breakeven inflation rate falling from a 2.75% high to 2.45% in January
    • As the Fed tightens policy by selling Treasuries, demand for the bonds will drop unless investors take up the slack. In turn, we expect buyers will need a higher yield for long-dated bonds, as the so-called term premium shifts
    • With the rate-hiking cycle about to start, five-year government debt seems to offer the most value. Such medium-term bonds are typically less price-sensitive to any potential volatility at the long end of the yield curve
  • Full article

    The dominating topic for financial markets so far this year remains the path of central bank policy. In America, since late 2021 the US Federal Reserve (Fed) has adjusted its policy stance which led to a to a repricing of the US rate curve. The radical change in the Fed’s direction has also altered our expectations for the path of policy rate hikes.

    We saw two to three hikes this year as possible towards the second quarter in our Outlook 2022 published in November. However, the change in tone in the Federal Open Market Committee’s (FOMC) December and January meetings, suggests that the Fed is now preparing to hike earlier, with three hikes, if not four, this year, starting with the “lift-off” in March.

    The change in tone...suggests that the Fed is preparing to hike...three, if not four, times this year, starting with the “lift-off” in March

    Over an extended period, Fed chair, Jerome Powell, defended the policy of letting the economy run “hot”, to ensure a wide job market recovery among various income and ethnic groups. This narrative has changed now, as headline inflation remains above 5% for the eighth month.

    “One of the two big threats to getting back to maximum employment is actually high inflation,” Powell said during a press conference1 . The tapering of current bond purchases is expected to be much quicker than had been expected, opening the door for a first hike in March.

    Has our outlook changed for 2022?

    In anticipation of the expected rate lift-off, the market has accelerated the flattening process with the two- and five-year point of the yield curve, moving them significantly upwards. A more determined Fed has provided more confidence that inflation can be tamed in the longer run. This increased confidence can be seen by lower trending inflation expectations, as the 10- year breakeven inflation rate consolidated from a 2.75% high to 2.45% in January. Is this the end-game, and what are the probable scenarios from here be?

    Two essential questions for rates

    The first question to be answered by the bond market concerns the timing of the lift-off, the number of rate hikes, and the likely end-point, or neutral long-term rate. The second question is what are the possible ramifications for the long end of the rate curve once the Fed starts to reduce its Treasury holdings?

    Policy rate end-game

    Listening to Jerome Powell and his colleagues, it seems that there is much uncertainty over the long-term neutral rate, that is the target policy rate that ensures full employment with inflation kept at bay. The Fed’s own “dot plot” forecasts suggest that the rate is 2.5%.

    During recent decades, the long-term neutral rate has been revised down consistently, not least because of the disinflationary environment, but also higher systematic bond demand and positive global productivity growth rates. Such a narrative seems broken in the near term. That said, given the excessive wage growth and the prospect of lower bond demand in light of the upcoming balance-sheet reduction, a return towards the historical trend seems likely in the long term.

    Gauging the pace of rate hikes

    The Fed seems to acknowledge that accommodation must be more dynamic along the path towards the “end point”. This is very important, as a potential faster pace of rate hikes does not necessarily indicate a higher end-point.

    Comments from Fed member Christopher Waller “If inflation is just stubbornly high through the first half of this year, we’re going to have to do a lot more,” would admittedly suggest a potential higher end-point. Indeed, Powell stated that “if we have to raise interest rates more over time, we will,” in front of the banking committee of the Senate in December.

    But a wage growth spiral and commodity cycle is unlikely to run forever and the Fed, like many economists, expects a trend to more balanced supply and demand in the future. While many older workers (over 55 years of age) may not necessarily return to the workforce again, younger ones will do so eventually. Living from savings is not a perpetual game for most. This should ease some of the wage growth pressure.

    The Fed is now trying to bridge the gap between a high inflationary period (how long it may last) and the period of lower inflation expected to follow. This separation could give Powell greater power to hike rates faster now. He said: “We would not in any way want to foreclose the idea that the labour market can get even better. But again, with inflation as high as it is we have to make policy in real time, we’ve got to make that assessment in real time.”2

    Surprises likely

    With this in mind, three US rate hikes this year, as suggested by the Fed’s dot plot, seems to be very likely. A fourth increase, as implied by current market pricing, is possible, but not set in stone. The Fed will get inflation data for two more months ahead of the March FOMC meeting.

    Higher persistent inflation may open up the potential for a surprise 50bp hike in March. This is not our base case, but only such a move would put a firmer cap on inflation expectations should breakeven yields, along with higher inflation readings in February and March, start to accelerate again. Such a move would potentially shift the rate curve higher, but may not necessarily mean a higher end point, as explained earlier.

    Impact of a shrinking Fed balance sheet

    In January, the FOMC stated that it “expects that reducing the size of the Federal Reserve’s balance sheet will commence after the process of increasing the target range for the federal funds rate has begun”. This implies that the reduction of the balance sheet may start in the first or second quarter of this year.

    Given the strong recovery in the economy, and what could be defined as full employment, a balance sheet of over $8.7 trillion seems hardly justifiable. A run-off, as soon as July, seems more on the cards now. “The balance sheet is much bigger so the runoff can be faster.”, argued Powell.

    Around $1.9 trillion of the Fed’s $5.6 trillion Treasury holdings mature in 2022 alone. The Fed would still reinvest a substantial portion of maturing debt to ensure a slower pace of runoff, potentially $15 billion to $30 billion a month to begin with, before a gradual increase towards $75 billion a month. This in turn could translate into a $1.2 trillion reduction by the end of 2023, or potentially $1.6 trillion if the runoff pace approaches $100 billion a month, $1.6 trillion which would need to be absorbed by private demand.

    Around $1.9 trillion of the Fed’s $5.6 trillion Treasury holdings mature in 2022 alone

    Higher term premium likely

    The demand-shift, and the uncertainty over the magnitude, is likely to result in a higher term premium, the additional yield investors demand for holding longer-dated bonds. This term premium is around minus 15bp, being as high as 200bp during the taper tantrum in 2013. A more orchestrated runoff, with still high accommodative policy, warrants only a slight increase in the term premium, potentially well below the 10-year average of around 30bp.

    Investors fearing a rate sell-off due to large Treasury supply from the US government which hits the private markets, should take into account that the US Treasury is likely to issue significantly less debt this year than in 2021, given a large bulk of the funding needs were front loaded last year. Secondly, much of the new supply is likely to come in the form of T-bills, which would hardly impact 10-year yields.

    Five-year yields with value

    In the scenario just described, we see a possibility for yields surpassing 2% potentially reaching even 2.25% temporarily. Should inflation abate over time, as we expect, yields of well over 2% seem rich in our view.

    While uncertainty over the pace and extent of the hiking cycle, as well as over long-end yields, remain, we see the belly of the curve at the 5-year point from a risk/reward perspective. This part of the curve is pricing in four hikes this year, and yields only 25bp less than 10-year bonds.

    This pricing is also reflected in the rate butterfly construct, which compares the 5-year yield against that available for the 2- and 10-year yields simultaneously. The butterfly comparison (see chart) shows that medium term 5-year bonds show a level of relative yield advantage seen only seven times in the last 30 years. This, along with medium-term bonds typically being less price sensitivity to any potential volatility at the long end, suggests that 5-year debt is likely to provide an attractive risk/reward for investors.

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