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Original title: Expectations of currency tightening heat up, U.S. debt short-end yields climb
Source: Futures Daily
Author: Cheng Xiaoyong
After the Fed’s June meeting on interest rates, the market generally believes that the Fed will release a signal to reduce QE in the third quarter. However, the bond market reacted differently. Short-end U.S. Treasury yields rose sharply, but long-end U.S. Treasury yields continued to decline, and the long-end U.S. Treasury yield curve flattened again.
The picture shows the 2-year and 10-year U.S. Treasury yields
Why does this happen? The author believes that there are several reasons:
First, the rise in short-end U.S. Treasury yields is mainly triggered by tightening expectations, which also reflects the market’s expectations for QE cuts in the third quarter, as 3-month and 2-year U.S. bonds are very sensitive to the Fed’s monetary policy. Looking back at the Fed’s signal to cut QE in 2013, the yields of short-end U.S. Treasuries also rose. From the content of the Fed’s interest rate meeting, we can find that several clues verify that the Fed will release a signal to reduce QE in the third quarter is more likely:
First, the Fed expressed an optimistic attitude towards US economic growth. When describing the economic situation, the Federal Reserve deleted the statement that the epidemic is suppressing the economy and stated that the progress of vaccination has reduced the spread of the new coronavirus in the United States. With this progress and strong policy support, economic activity and employment indicators have strengthened. The sectors most adversely affected by the epidemic are still weak, but have shown improvement. The Fed slightly raised its economic expectations for 2021. The Federal Reserve currently predicts that the real GDP of the United States will grow by 7.0% in 2021.
Secondly, regarding the triggering conditions of monetary policy adjustments, Powell said that the path to asset purchases will be discussed in the near future, and there is “a long way to go” to reach the standard of reducing bond purchases. But the economy is moving towards the goals of the Fed, and policymakers will assess the appropriate time to start reducing the scale of debt purchases at future meetings. Powell even said that if you want, you can regard this meeting we are holding as a “discussion on reducing the scale of debt purchases.”
Third, the Fed made a technical adjustment to the reverse repo interest rate at this meeting, and the short-end interest rate was the first to increase. The excess reserve interest rate (IOER) was adjusted from 0.1% to 0.15%, and the overnight reverse repo interest rate was adjusted from 0 to 0.05%, effective from June 17. This means that short-term liquidity in the US money market has put pressure on the Fed, and the Fed has been forced to recover liquidity by raising short-end interest rates.
Finally, the improvement in employment has turned from previous pessimism to improvement, which may be the most important factor that triggers the Fed to cut QE. In terms of employment, Powell said that 2022 will be a “very good year” when wages are rising. Economic growth will create a lot of job opportunities. We believe that the supply and demand in the labor market will reach a balance in the next few months, and jobs will be created from summer to autumn. Strong, concerns about the new crown pneumonia epidemic and other factors that hinder labor supply should decrease in the future. Powell believes: “It is clear that the factors affecting employment growth should be weakened in the next few months, and we are moving towards a very strong labor market.”
Second, from the perspective of the flattening of the long-end yield curve of U.S. Treasury bonds, the Federal Reserve’s FOMC statement shows that the adjustment of the interest rate on excess reserves from 0.1% to 0.15% may have an impact on the flow of the money market, due to the short-term flow of a large number of financial institutions Sex is rampant, and money has to be returned to the Fed through the Fed’s reverse repurchase tool. After the Fed raised the interest rate on excess reserves, banks were forced to contract assets and liabilities, which triggered a sharp rise in short-end interest rates.
Third, the decline in long-term U.S. Treasury yields is mainly the result of concerns about economic growth prospects and the fall in inflation expectations. In 2010, with the expiration of QE1 and various stimulus policies, the US economy lacked momentum, and economic data such as consumption and housing sales quickly weakened. At that time, the US long-end interest rate also fell, which led to the flattening of the interest rate curve. The current situation is somewhat similar to that in 2010. As the market expects that easing policies will gradually withdraw, expectations for economic growth are also weakening, resulting in a flattening of the interest rate curve.
In terms of inflation expectations, the trend of 10-year US break-even inflation rates shows that investors have reduced their bets on longer-term inflation. On June 21, the 10-year break-even inflation rate, a measure of long-term consumer price inflation, fell back to 2.25% from the mid-May high of 2.54%, but it was still near the highest record since 2012.
However, we believe that if U.S. inflation lasts longer than expected, then long-end U.S. Treasury yields will stop falling and rebound. On the one hand, the U.S. job market is experiencing structural tension. In May, the number of job vacancies rose while wages rose. Recently, the number of job vacancies in the United States has reached 9.29 million. In 2019, there were almost 7 million. The job vacancy rate was as high as 6%, and the average level in 2019 was 4%. On the other hand, the recovery of the global supply chain is also subject to the epidemic and the inflationary pressure brought by the recovery of the US service industry. With the expansion of the scope of vaccination in the United States, more than half of American adults have now been fully vaccinated, which has increased the demand of American consumers for air travel, hotel accommodation, dining out, and entertainment. In contrast, the retail of physical goods has been squeezed.
Therefore, while inflation remains high, we continue to look at U.S. Treasury yields, and the yield curve will continue to flatten. Because economic growth is weak under high inflation, long-end U.S. Treasury yields will rebound moderately, but short-term U.S. Treasury bond yields rebounded even more. If inflation is temporary and the job market improves, the Fed will still cut QE. At that time, the long-term yield will rise more than the short-term yield, and the yield curve will steepen again. The author prefers the first scenario, so investors can consider using CME Group’s 2-year US Treasury futures to hedge short-term interest rate upside risks or capture investment opportunities. (Author’s unit: Baocheng Futures)
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