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US yield curve debate reaches fever pitch

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This week sees potentially important data releases and highly anticipated rate signalling from the FOMC. The week begins with US inflation data and ends with employment data – including non-farm payrolls on Friday. The Federal Reserve holds a two-day policy meeting ending on Wednesday with the release of its latest statement. Meanwhile, the US treasury will detail quarterly government debt sales. As in recent weeks, a key focus – for both US bond investors and those further afield – will be whether the 10-year Treasury note yield can go beyond its 2014 peak of 3.05%.   
 
The heavily analysed breach of the 3% level last week by the benchmark 10-year US government bond ties in with a curve that has broadly risen in 2018 but, perhaps more importantly, has flattened: the yield difference between two and 10-year bonds now stands at just 50 basis points.  Exactly what this implies about the bond market’s view of the broader US economy is the subject of some debate. On the one hand, higher yields are the expected reaction to better economic conditions, higher growth, and less vulnerable inflation dynamics all of which point towards a boost to corporate earnings. On the other hand though, higher yields, by influencing the discount rate applicable to future corporate cash flows, imply a higher risk premium for stocks and other risk assets and thereby exert a downward pressure on their prices.

Moreover, the flat curve (which many commentators would argue is heading towards inversion) would traditionally imply that bond investors are anticipating a period of considerable economic slowdown. However, it could be that what we are seeing with the flattening of the curve is the long-term consequence of the unprecedented quantitative easing programme that the Federal Reserve is the first central bank to begin to rein in. Holders of longer-term bonds have become accustomed to selling to central banks that are not sensitive to price as they have been acting under the policy guidance of quantitative easing. Central banks have applied forward guidance to artificially depress long term yields and reduce the likelihood of market surprises.
 
Simultaneously, the shorter-dated Treasury yields have been increased more quickly by the Fed hiking rates at the same time the Treasury has to sell a larger amount of government debt than it has in recent years. The combination of these factors points towards a less-than-perfect signalling effect from the bond market/yield rate curve to the overall economy. As central banks globally begin to intensify their quantitative tightening and the bond markets return to ‘normal’, the shape of the yield curve will begin to better reflect the predicted path of the underlying economy.
 
A hawkish statement from the Fed on Wednesday will pile pressure on the two-year yield. The Fed is expected to guide the market towards expecting a rate increase over the summer most likely keeping borrowing costs at 1.5-1.75% and line up a 0.25% rise for the meeting on 13 June. The Fed itself currently forecasts a total of three hikes in 2018, the first of which was enacted in March. With unemployment at just 4.1% and a consensus that it will drop to 4.0% on Friday along with non-farm payrolls at 185,000, some economists are predicting a more hawkish year with four hikes.
 
Indeed, the economy is expected to gain from the boost of $1.5tn tax-cutting package and higher public spending. Then again, the major uncertainty that could spoil this picture is the potential for a significant deterioration of trading relations between the US and its partners. Unfortunately, discounting this possibility is tantamount to a bet on President Trump’s temperament that few market participants may be willing to make. The only firm prediction we can offer for the US yield curve is that the debate surrounding it is unlikely to die down any time soon.        

 

All views expressed here are the Author’s own and are based on information available at the time of writing

 

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