Global Rates Landscape:Will the Fed's balance sheet unwind lead to a sell-off in bonds?
Bonds are unlikely to be affected by stopping of Fed reinvestments in H2 2018.
With the recent FOMC members' talk about cessation of reinvestments, marketparticipants have become quite concerned about the impact on US yields. Here weprovide a framework to analyse and to quantify the impact of a potential balance sheetunwind on US long-term yields. We estimate that unwinding the balance sheet in Q32018 would increase bond (term) premia by c. 40bps. The market is already pricing this,but an earlier unwind could lead to a steeper curve and 25-30bp yield shock.
Why is the Fed unlikely to surprise the market.
We think the Fed will follow its guidance, hike rates first and shrink the balance sheetlater. It makes sense from the Fed's perspective not to start unwinding the SOMAholdings until policy rates are well above the zero bound leaving a cushion for theFOMC if the balance sheet reduction has any unexpected effects. Consistent with theprimary dealer survey, we do not expect the Fed to cease reinvestments until H2 2018.
US: UST 10y forecasts revised up but we remain bullish on duration.
We revise up our UST 10y forecast to 2.40% by end-17 to reflect a more positive globalbackdrop. Recent data out of the US has shown signs of momentum and financialconditions remain supportive. Aging demographics, low productivity, and the globalsavings glut should keep neutral real rates low. Long-term inflation expectations are notconsistent with high level of real rates. Most importantly, we have little evidence onfiscal spending and the bond market has already priced for material fiscal easing.
Tactically, we recommend 5s30s nominal/real curve flatteners ahead of March FOMC.
Euro area: Despite existential political risks, do not lose sight of fundamentals.
Political risks challenging the euro area's integrity remain unlikely to materialise. Nearterm,further risk aversion with volatile EGB spreads prevails. Assuming political hurdlesare cleared the solid economic recovery should get more attention. We adjust our 10yBund forecasts above forwards until 2018 and have a strategic short duration bias. Atthe moment outright short OATs, 10y US vs. German real rate tighteners and 5s30sBund steepeners hold better risk reward, though. We close receiving 2y1y Eoniaforwards as risks are shifting. In the EGB space, we refrain from spread positioning andextend targets for our recommended French and Italian curve flatteners vs Bunds.
UK: Softening growth vs high near-term inflation.
Despite near-term inflationary pressures, the economy is set to soften driven by aslowdown of investment, corporate spending and consumption. We expect the MPC toreturn to an easing stance via a rate cut and more QE in Q4. We stick to receiving 2y2yswaps, long 30y Gilts vs Bunds, short 5y5y inflation and 10y US vs UK BEI tighteners.
Japan: A curve/breakeven conundrum.
The back-end of the Japanese curve has steepened considerably in 2017, in spite offalling breakevens and higher real yields. Going forward, we see the path of leastresistance favouring further curve steepening – but chances are it will be accompaniedby lower real yields. We continue to favour Japanese real yields vs. Germany (Bundeis).
Australasia: Opportunities post recent central bank action.
While the RBA struck a surprisingly positive tone recently, the RBNZ talked down anyprospects of near-term rate hikes. This has seen Kiwi rates outperforming, with thefront-end out-steepening Australia and the US alike. We discuss three (two bullish andone bearish) NZD rates positions we like post recent market moves.