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Don’t expect US bond yields to move up very much

The essential

The Fed is expected to begin its Fed Funds tightening cycle soon, and the spotlight is therefore on the US bond market.

And yet, US long-term yields have little room to move up, particularly as the Fed Funds tightening cycle will be of very limited scope. Moreover, the Fed is unlikely to stop reinvesting the proceeds from maturing Treasuries that it holds any time soon.

 

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For some time now, FOMC members have raised the possibility of a hike in the Fed Funds target rate, which has been close to zero for almost seven years. So now is a good time to ask what impact this might have on the US yield curve. As we will see, there are several reasons why long-term rates cannot rise too sharply.

Let’s first look at the fundamental reasons. The monetary policy cycle that we have just witnessed has been completely atypical (see box), and the next one will probably be just as atypical. The tightening in the Fed Funds rate will be of a far lesser extent than during previous cycles, and the tightening will also be far slower. There are several reasons for this, the main one being the sharp drop in US potential growth. In late July the Fed inadvertently revealed that its economists considered that US potential growth was now hovering around 1.70/1.80%. One consequence of this is that the na tural real interest rate – usually used as a constant for the Taylor rule – islower than it used to be. Several FOMC members, including Janet Yellen, now estimate it at 0%, vs. 2% during the previous cycle. The Taylor rules, which FOMC members say they are moving back to, say that the Fed Funds rate will be at the very low levels of 1.5% at the end of 2016 and 2% at the end of 2017. The market is pricing in a level that is even more pessimistic.

The Fed sees many obstacles: monetary policy divergence, which is driving the dollar up and undermining the recovery; deflationary pressures from China (see Nicolas Doisy’s article in this publication); the slow-to-come acceleration in wages; risks of destabilising the equity market; and so on. In other words, the Fed Funds tightening cycle is likely to be of an even more limited scale than the Fed currently believes.

It is useful to keep in mind that long-term yields are generally at the level of the Fed Funds rate at the end of a monetary cycle. Assuming that the terminal rate during the coming cycle is 2% or, worse, 1%, that would mean that US longterm yields are already relatively high. The yield curve is likely to flatten through an increase in its short segment.

Technical factors could play a decisive role in the coming quarters. Of the $2480bn in Treasury bonds held by the Fed, $232bn is set to mature in 2016, including $92bn between February and April 2016. What will the Fed do then? During the September 2014 FOMC the Fed had explained:

  • That it would reduce its holdings gradually and predictably by no longer investing the proceeds of maturing securities;
  • That it would no longer reinvest the proceeds of maturing securities after beginning to raise the Fed Funds rate and that the timing would depend on the economic outlook and economic and financial conditions;
  • That it had no plans to sell MBS.

Theoretically, if the Fed no longer reinvested the proceeds of Treasuries, that should tend to push long-term rates upward as it would expand the supply of Treasuries available to investors. For example, the Treasury will repay $37bn to the Fed in February, whereas net issuance of long-dated bonds is currently about $50bn. Reinvestment would mean net supply for investors of about $50bn, whereas non-reinvestment would mean net supply of $87bn. That said, judging by the foot-dragging of FOMC members just as regards the first Fed Funds hike, but also by the chronic weakness in inflation and wages (acceleration of which is supposed to ensure that inflation rises to the 2% target). The Fed is very likely to take its time before it stops reinvesting the proceeds from maturing bonds, and this will probably not happen until at least the second half of 2016. During a 5 June speech, William Dudley, chairman of the New York Fed, said that he felt non-reinvestment should not begin until the Fed Funds rate had reached a “reasonable level”. Given how slow the coming tightening cycle is likely to be, we can be reasonably confident that the Fed will continue to reinvest proceeds from maturing securities for some time to come.

That said, technical factors that are playing a more prominent role than they accustomed are not limited to just the Fed. As we saw in the 2000s with the famous “conundrum” (Alan Greenspan’s expression) regarding the “unexplained” weakness in US bond yields, which was actually was due to massive purchases of Treasuries by Asian central banks, foreign official intervention can have a very heavy impact on the bond market. In particular, China holds more than $1200bn in Treasuries. In recent months, the PBoC has sold Treasuries massively to keep the yuan from depreciating too much vs. the dollar (capital outflows have exceeded $800bn over the past 12 months). However, if the PBoC was to continue selling Treasuries, management of Treasuries held by the PBoC is unforeseeable and it is hard to imagine that the Chinese authorities would quickly liquidate this source of national wealth.

Moreover, international investors have been net sellers on the European bonds markets for several quarters now, due mainly to low (and, in some cases, negative) yields, and have been switching in part to US bond markets, which offer more attractive yields. This is also weighing on long-term yields.

In conclusion, US long-term yields are unlikely to rise sharply, even if the Fed begins its monetary tightening cycle.

An atypical monetary policy cycle

For some time now, FOMC members have raised the possibility of a hike in the Fed Funds rate, which has been 0.25% since December 2008, i.e., almost seven years. Here is some background. Back then, the real-estate slump and the Lehman Brothers bankruptcy had triggered the most serious economic and financial crisis of the post-war period, with major repercussions worldwide. In the United States, almost 9 million jobs were destroyed, and the unemployment rate rose to 10% (a high since 1983). The crisis was so severe that the Fed cut the Fed Funds rate from 2% just before the Lehman Brothers bankruptcy (in September 2008) to 0.25% a few months later, and then launched several asset-buying plans to promote a recovery.

Little by little, and at a hardly impressive pace, the US economy emerged from the Great Recession, and the jobless rate declined steadily to 5.1% in August 2015. About 12 million jobs have been created since the start of 2010. The jobless rate is now close to its equilibrium level (about 5%, according to FOMC members), below which wage pressures and then inflationary pressures are supposed to materialise. The Fed phased out its securities purchases (i.e., its unconventional policy) in 2014 and is now raising the possibility of a hike in its key rates (conventional policy).

In addition to purchases of securities (which have already been commented on in depth in this publication), the monetary policy cycle will also have been atypical in that the Fed Funds rate has not been in phase with the economic cycle, in contrast to recent decades, due to the Fed Funds’ positivity constraint. The Fed Funds rate has traditionally been in phase with business investment as a percentage of GDP. This link has been broken in recent years, as the business investment rate has risen since 2010 to levels that are still lower than before the recession, while the Fed Funds rate has remained close to zero. The explanation is in the fact that very low interest rates have been insufficient to boost demand, which is far weaker than it used to be.

 

 

 

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The Fed Funds tightening cycle is likely to be of an even more limited extent than the Fed currently believes

 

The Fed is very likely to take its time before it stops reinvesting the proceeds from maturing bonds

 

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Cross Asset of September 2015 in English

Cross Asset de Septembre 2015 en Français

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DRUT Bastien , Fixed Income and FX Strategy
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Don’t expect US bond yields to move up very much
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