Outlook For The U.S. Yield Curve

Our U.S. bond strategists expect the U.S. yield curve to steepen further in 2017.

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The steepening should be driven by improving growth, rising inflation expectations and a lagging Fed. We believe that the Fed will remain accommodative at least until TIPS breakeven inflation rates are in a range that is more consistent with the 2% inflation target. That range is between 2.4% and 2.5% for long-dated TIPS breakevens.

However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. We view a “dovish hike”, i.e. an increase in the fed funds rate with no upward revision to the Fed’s interest rate forecasts, as the most likely outcome. However, if we are wrong, an upward revision to the Fed’s forecasts would cause the curve to bear-flatten on the day.

At present, the market expects 59 bps of rate hikes during the next 12 months. If expectations remain at these levels until after next week’s FOMC meeting, they will be consistent with the Fed’s median forecast, assuming there are no upward revisions.

Also, as we pointed out in a previous Insight, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year.

ECB Pulls Off A Dovish Taper

The European Central Bank (ECB) announced that it will taper asset purchases from €80 billion per month to €60 billion beginning next April. Long-term bund yields increased on the news, but other markets responded as if the ECB had eased policy: Eurozone stock indexes rose and the euro weakened.

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This market reaction suggests that investors have interpreted the ECB’s action as dovish, or at a minimum, benign. In part, this may reflect the extension of the program to year end, and perhaps beyond that if inflation is expected to remain below the ECB’s 2% target. The market was expecting an extension of the €80 purchase pace until September. Instead, the ECB will buy at a €60 billion pace until (at least) the end of the year, which works out to a larger accumulation in total.

Moreover, President Draghi was careful to manage expectations, which limited market fears that the central bank is getting closer to ending the purchase program and beginning to lift interest rates:

  • The ECB trimmed its inflation forecast for the coming years. Draghi emphasized that inflation is too low and that, outside of base effects from energy prices, there is little upward momentum in inflation at the moment.
  • Draghi also emphasized that the asset purchase program is open-ended and could be ramped up again were the economy to need it. Moreover, he said that “the presence of the ECB on the markets will be there for a long time.”
  • The ECB removed the self-imposed rule that it cannot buy bonds with a yield that is below the deposit rate (-40 basis points), while also lowering the minimum maturity for bond purchases to one year. This depressed yields at the front end of the sovereign Eurozone curves and reinforced the notion that the ECB is a long way from raising interest rates.

The implication is that a liberal dose of “forward guidance” has limited the damage from the reduction in the pace of asset purchases.

Our bond strategists shifted tactically to benchmark on global duration following the past month’s major selloff. On a 12-month horizon, we still believe that global yields will be higher than forward rates, but this is largely due to our bullish view on the U.S. economy. Bund yields will be dragged higher by the global selloff, but the U.S./Eurozone monetary and fiscal policy divergence will likely see Treasury/bund spreads widen further. The divergence should also weaken the euro.