Treasury Bears on Reflation Train Face Peaking Price PressuresBy
Waning energy base effects likely to damp inflation forwards
Fed terminal rate lacks escape velocity, awaits fiscal policy
Bond bears in the U.S. are feeling the squeeze.
Investors need to contend with the waning impact of energy base effects on inflation and a terminal rate that lacks momentum before they can aspire to push interest rates higher.
A tighter Federal Reserve policy may also prevent longer-end inflation from accelerating much further, with five-year inflation forwards due in five years already at about 2.40 percent, matching policy makers’ consumer-price inflation target. This may reduce demand for long-dated payer skews -- which typically increase on higher inflation expectations -- as pension funds may be less willing to pay an inflation-risk premium.
The one-month Treasury rate, two years forward -- a proxy for the Fed’s terminal rate -- has already discounted about five increases of 25 basis points over the next two years and remains almost 30 basis points below the December highs, with inflation well-contained for now. A higher terminal rate requires fiscal-policy expectations to play out to script or the term premiums to move higher.
The iShares 20+ Year Treasury Bond ETF, an exchange-traded fund that seeks to track the investment results of an index comprising U.S. Treasury bonds with remaining maturities greater than 20 years, is yet to break down from the 2011 trend line. A break of the line would imply higher yields.
Bulls now face more symmetric risks with lower volatility and a flat skew, reducing the cost of optionality. The lofty fiscal expectations surrounding President Donald Trump have subsided, leading to cheaper implied volatilities to hedge against the risk of higher rates over the next few quarters.
Bearish risks may also stem from the potential for euro-area yields to go higher if there is increased re-pricing that the European Central Bank will start raising rates before the end of its quantitative easing. However, the ECB also faces peak inflation pressures as stubbornly low core inflation increases complications for policy makers at a time when the central bank is getting closer to the limit above which it can’t buy German bunds further.
The short-dated skew between payers and receivers on 10-year yields is flat, with the risks now more symmetric for rates, allowing investors to position for outcomes following the U.S. fiscal debate. Steeper skews would indicate payers richening relative to receivers, signaling expectations for higher rates.
Another factor that bears need to contend with is overseas demand for Treasuries. The cost of currency-hedging for dollar assets has cheapened for Japanese investors, with the three-month basis now at the two-year average. Japanese life insurers typically buy domestic bonds in March and foreign bonds in the first half of the fiscal year that starts in April. This may help keep U.S. 10-year yields below 3 percent.
* NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.
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