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Can Fed check the TNote’s downturn?

The rise in the yield of the 10-year TNote has been impressive since the start of May, up from 1.60% to 2.90%, its highest level since July 2011 (TNote contract has shed around 6%). The steepening of the US sovereign yield curve has been just as impressive, as the 10-2Y spread has widened to 250bp from around 140bp at the start of May.

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This spread is also at its highest since July 2011. The determinants of this re-pricing of the US curve are well known:

1. The forward guidance protects the short end of the curve, especially since the Federal Reserve is apparently discussing the opportunity of lowering its unemployment rate target below which it could envisage raising the federal funds rate target. This discussion is probably tied to the behaviour of the Fed funds futures, as they price in an interest rate hike as early as the end of next year. A few weeks ago, no increase in the Federal funds was priced in before the start of 2015.

2. Prospects of a QE3 tapering is weighing on the long end of the curve (currently, purchases by the Federal Reserve “cover” one quarter of TNote, TBond and TIPS issuance). It is not yet totally certain this tapering will get under way in September, but for long-dated issues it matters not greatly whether this tapering begins in September or December: the issue is not “if” but rather “when” and “how”. What matters for the market is that the signal has been given. Currently, investors expect asset purchases by the Federal Reserve to end mid-2014. They will react (positively or negatively) if comments by the Federal Reserve when it announces the actual tapering do not confirm this timing.

If one considers real yields, it will be observed that much of the yield curve has clawed its way out of negative territory: currently, TIPS maturing in more than 6 years offer positive yields. At the start of the year, only TIPS maturing in more than 20 years offered positive yields. At the start of 2010, no TIPS maturing in more than 3 years offered negative yields. At the start of 2008, real yields were positive right across the curve (weakest real yields were around 1%).

The rise in TNote yields results from the following phenomena: 1. In the short term, therefore, prospects of the tapering getting under way. 2. Longer term, prospects of a rise in the Federal funds rate target (in principle once the unemployment rate has pulled back below 6.5% or lower still if the threshold is revised downwards). 3. Anticipations of stronger growth (US economy is turning in very honourable performances, especially considering the fiscal tightening has reduced growth by around 1pp in 2013 alone). 4. And probably, the Federal Reserve’s intention to normalise monetary policy as soon as possible, in other words once growth is self-sustained or, as Mark Carney would say, once escape velocity has been reached.

It may be the Federal Reserve will succeed in calming the markets in September. However, many of the above phenomena are irreversible, save if the improvement in the economy is short-lived and deflation gradually takes hold in the US. What is still not known is their velocity (for one thing, the Federal Reserve has not made firm commitments regarding its balance sheet policy come mid-2014). There may be some offsetting at flow levels, but it does seem that the rise in TNote yields will be a lasting phenomenon. A 3% yield for the 10Y TNote is no longer outlandish, but what awaits tomorrow. As regards the curve, the Federal Reserve’s rhetoric points to a further steepening (the possibility that the 6.5% unemployment rate threshold could be lowered affords more protection to the short end than to the long end). The Federal Reserve clearly wants to disassociate the balance sheet policy from the interest rate policy (i.e. non conventional measures from conventional measures). Indeed this is such that the two policies could, in appearance, go their separate ways to a large extent. It is this quasi-divergence of policies that could lead to a further steepening of the yield curve in the near term.

René Defossez , August 2013

Article also available in : English EN | français FR

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