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