US Treasury market not following Fed’s lead yet

Outlook from fixed-income strategists hasn’t changed

BENGALURU, June 24, (RTRS): US Treasury yields are forecast to climb over the coming year, but the outlook from fixed-income strategists hasn’t changed much in the past three months, in the latest sign that optimism about a global inflation pickup has at best plateaued.

The latest Reuters poll of over 60 strategists at bond dealers and research institutions, taken June 19-22, suggests yield rises over the next year will at best track the Federal Reserve’s current intended rateincrease path.

Since the last poll, the Fed has raised the federal funds rate once more, this month. But market conviction on the likelihood of a another rise as soon as September has fallen back, along with inflation expectations.

Rather than steepen as would normally be the case as inflation picks up, the US yield curve has flattened, a move generally seen by financial markets in this stage of an economic cycle as a harbinger of potential trouble ahead.

But global stock markets have been buoyant.

While the poll forecasts no major changes to the spread between twoyear and 10-year notes from three months ago, the spread between fiveyear notes and 30-year bonds is the narrowest in nearly a decade, when the financial crisis was gathering pace.

This has coincided with an extended period where economic data have been coming in consistently weaker than economists’ forecasts, providing scant evidence the economy is poised to break out of a roughly 2 percent steady trend growth rate.

At the same time, many have dialed down expectations that the Trump administration will be able to get dramatic tax cuts through the US Congress, and calls are getting louder for the Fed to consider a pause.

“The fact the Fed hiked rates in June and continued to signal further hikes to come certainly has the makings of a policy error,” wrote Matthew Hornbach, global head of interest strategy at Morgan Stanley, in a research note.

“But we think it’s more than just that. In the context of weaker US data, 10-year yields looked and continue to look attractive relative to other developed market sovereign 10-year bond yields.”

Natural demand for Treasuries when investors globally are looking for a safe place to park their money but that still pays a yield - is also likely to keep yield rises restrained, especially if stock markets slip from record highs.

Some consensus expectations for sovereign yields, notably for UK gilts, have shifted lower from where they were just three months ago, suggesting that a burst of imported inflation from the plunge in the pound won’t be sustained.

The outlook for the British economy one year after Britons voted to leave the European Union has darkened, with households now getting squeezed as prices rise faster than their pay.

But even fixed-income strategists as a group appear to be conflicted between sticking to subdued bond yields and their own assessment of the Fed’s policy path when asked directly about it.

A majority of respondents who answered an extra question said they were confident the Fed will follow through broadly on its plans to raise rates, rating the central bank’s latest inflation outlook as just about right.

Taken together, the responses suggest the risk is not that inflation expectations will take off and the Fed will need to do more, but that it may be forced to be even more gradual.

“If they go too fast, then the end result of that is actually that the market is going to take a more bearish view,” said Elwin De Groot, senior market economist at Rabobank, explaining how the bond market is pushing against the Fed, as it has done for most of the period since the financial crisis.

The latest Reuters poll median puts the US 10-year Treasury yield at 2.90 percent in a year, the same forecast as made in the March poll.

That year-ahead forecast is similar to what was predicted in December 2014, when the Fed had just begun winding down its quantitative easing programme.

Since then, the Fed has shut down the programme and has raised the funds rate by 100 basis points. This is a measure both of how chastened forecasters have become since then on their predictions for a “normalization” of the yield curve as well as ongoing plentiful investor demand for Treasuries.

The spread between 10-year Treasuries and much lower-yielding German bunds over the forecast period is predicted to hold roughly steady at around 210 basis points compared with just three months ago.

That reflects an ongoing divergence between the policies being pursued by the world’s two largest central banks — one tightening and the other purchasing tens of billions of bonds a month — and suggests no imminent changes to either one.