After struggling for months to separate market expectations for tapering from the start of the tightening cycle, there is evidence that these two events have finally desynchronized.
The chart above shows that the Fed’s message about de-linking tapering from tightening is getting through. Nevertheless, tightening will follow tapering with a lag and the current divergence may reflect a one-time adjustment that simply defers the expected lift-off date relative to the prospective end of the LSAP program.
Our U.S. Bond Strategy service remains short duration – the 10-year Treasury yield could rise to 3.25% as the LSAP program is wound down, based on a normalization of the term premium alone. Also, our fixed income strategists favor credit over convexity risk in 2014 based on an expectation for a cyclical recovery combined with peak monetary stimulus. Still, some volatility associated with the end of the asset purchase program is likely, similar in effect though probably lower in magnitude than what occurred last June when Chairman Bernanke first introduced a possible tapering timeline.
Although bearish on bonds on a cyclical investment horizon, a sharp rise in 10-year yields would prompt us to re-evaluate our duration call. A tactical shift to neutral duration may be warranted if the term premium quickly returns to equilibrium, about 50 basis points above current levels.