Bond market's 'game of chicken' with Fed is set for a reckoning
San Francisco
INVESTORS are again reassessing one of the bond market's premier reflation trades - the curve steepener - as expectations for growth and inflation perk up at a clip that was hard to imagine just a few months ago.
Whereas back in December, the thought was that the US Federal Reserve might tamp down long-term Treasury yields, the issue now lies with shorter-dated ones - five-year rates. Yields on that maturity have become unmoored in recent weeks, surging amid speculation that the central bank will need to start a cycle of rate hikes perhaps a full year earlier than officials have indicated. That shift has roiled the outlook for a classic iteration of the reflation wager, a widening gap between five- and 30-year yields, even as the narrative of a stimulus-fuelled recovery has only gained momentum.
The key takeaway is that the bet on a steeper curve isn't kaput because yields are still generally seen as rising further. It's just due for a re-think. For example, it may mean ditching the wager if it's grounded on the five-year note, which reflects a medium-term view of the Fed's path, in favour of one based on the two-year, which still remains anchored in the market's eyes.
This backdrop only intensifies the focus on the Fed's March 16-17 meeting, officials' next chance to counter speculation that tightening will begin as soon as late next year.
"The Fed... will have to walk a fine line between either pushing back against market expectations or allowing them to stand," said Kevin Walter, co-head of global Treasuries trading for Barclays. Without Fed pushback, he said, "there might be more pressure on the belly of the curve," in which case the best steepeners would be the spreads between two-year yields versus five- and seven-year rates that have room to rise as traders price in tightening.
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The swaps market is reflecting a roughly 75 per cent chance the Fed lifts rates from near zero by around the end of 2022. Mr Walter expects no major policy changes this week and anticipates that officials will continue to project rates on hold through 2023.
Five-year inflation expectations at the highest since 2008 and robust jobs data have only reinforced bets that the Fed will need to tighten more quickly than it's been forecasting. The speculation has squeezed wagers on a steeper curve from five to 30 years, shrinking that spread to a bit above 150 basis points, from a more than six-year high of 167 in February. The five-year yield at 0.84 per cent isn't far below its highest level since last year.
But the two-year has remained near historic lows on the view that the Fed will hold rates near zero for the immediate future. That's kept bets on the widely watched spread to the 10-year rate in play, as well as versus other maturities, such as the five- and seven-year.
"Some steepeners are better than others," said Patrick Leary, senior trader and chief market strategist for Incapital. He expects the two- to 10-year spread to keep widening, but has taken profits on steepeners and is looking for a better point to re-enter.
Some still see potential in the five- to 30-year steepener.
For Incapital's Mr Leary, the narrowing in the 5s30s gap came on the view that officials may discuss - or even announce - a twist this week. Such an operation, involving the sale of shorter-dated holdings and purchase of longer maturities to control yields, would put more pressure on the belly, he said.
"All these trades are highly dependent on the Fed being on the sidelines and not changing its policy stance," Mr Leary added. "The market is definitely playing a game of chicken with the Fed, by testing how high yields can get before tightening financial conditions and forcing the Fed to step in." BLOOMBERG
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