24 June 2021
The Fed leads the way
With the Federal Reserve signalling that rate hikes could lie ahead, we look at the prospects for global bond yields.
Last week’s Federal Open Market Committee (FOMC) meeting was an acknowledgement that fiscal support this year has not only short-circuited the usual disinflationary dynamics following a recession, but also that the distribution of possible inflation outcomes has widened. The Federal Reserve’s “dot plot”, which shows that most FOMC members expect rate hikes by 2023, has effectively established a new reaction function, with the raised forecasts in response to higher inflation likely to spark a further rise in shortdated yields if inflation continues to surprise to the upside. With the Federal Reserve (the Fed) signalling more explicitly that it will tighten policy in response to higher inflation, the market’s ability to run away with a reflationary narrative (as seen earlier this year) is now more limited. Looking beyond the US, other central banks will have to take the Fed’s stance into account, whether explicitly or implicitly, not least because of the currency dynamics at play. The market can therefore price rate hikes more easily in the developed economies that can generate inflation, such as the UK, Canada and Australia. Japan’s structurally low inflation means we can expect no change to the rates environment there, while the eurozone falls somewhere in the middle, with an inflation outlook that doesn’t support a sustained shift towards a tightening cycle, but with a chance that the market could tactically price tighter European Central Bank policy, perhaps later in the summer. What seems clear is that the narrative coming from the Fed is likely to dictate the pace of monetary tightening across much of the globe.
Rates hikes are priced in by the market in the economies most capable of generating inflation
Before the FOMC meeting, the US 10-year Treasury yield was 1.48%. There was significant price volatility throughout the week following the meeting, with rates trading as high as 1.58% initially and as low as 1.36%. Since 21 June, however, yields have stabilised at around 1.47%, suggesting that the market has self-corrected and that the news has now been priced in. Given the ongoing economic recovery, rates can move higher over the coming months, although any rise will likely need to be driven by higher real yields (one component of nominal yields), rather than breakevens (the other component, which reflects inflation expectations). The yield on US 10-year breakevens had climbed steadily over the past year from 1.36% to as high as 2.56% in May, but has fallen off in recent weeks to around 2.32%, with less potential to rise further given the Fed’s newly established reaction function. Thus, higher real yields will be needed to push rates higher, which could impact risk markets in the event of a sharp repricing.
The main driver of rates in the coming months will be the incoming inflation and jobs data, and how the market interprets the Fed’s reaction to these. Technicals will therefore likely not be a main driver, but it is worth taking note of current positioning. Our indicators suggest that the market consensus is broadly short rates: in particular, looking at CFTC (Commodity Futures Trading Commission) data, investors appear to be short at the back end of the curve. The risk of such positioning being overextended appears to have diminished, however, with short positioning reducing steadily in magnitude over recent months.
What does this mean for fixed income investors?
The Fed’s hawkish shift has reduced the prospect of runaway inflation and put a cap on breakevens, meaning that further moves higher in Treasury yields will likely be driven by the real-yield component of rates. Real yields could rise if growth accelerates faster than expected and the Fed is forced to act sooner than signalled. This narrative is also likely to spill over to economies capable of generating sustained inflation. In a real-yield repricing scenario, risk assets could come under pressure. But for now, with the economic recovery progressing steadily, and with the Fed on top of the inflation data, this should remain a stable environment for carry.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum