I still like the flattener and believe the market is providing an opportunity to get into the trade at better levels (than recent levels). I like the flattener in Europe (even more than in US). I believe several 2’s 10’s curves in the EU are likely to go to ZERO. The CB’s implementing ECB QE will want to buy positive yielding securities. Even though the cap is -0.20%, they are unlikely to buy negative securities. As the shortage of willing sellers gets scarcer, I believe rates will attempt to grind toward 0%. German 2’s yield -0.21% (below the cap), while 10’s yield 0.0.34%. I can envision this curve at zero even as economic data in Europe is better than expectations. A flattening curve in Europe would place flattening pressure on the US curve as well.
On a separate note there is another factor that may arise going forward. During the last several years of uber-accommodation by the Fed, both stock and bond prices rose. It would not be surprising if both fell in price as the Fed proceeds with a June “lift-off”. However, stocks might be the worse of the two performers. I expect rising market turbulent and expect a terminal fed funds rate of only 0.75%-1.00% into mid-2016. The Feds balance sheet has $400 billion of maturities to deal with in early 2016 which the market place is not paying enough attention to. I believe the Fed will want to allow as much of this as possible to roll off (i.e. the balance sheet will shrink). The decline in the Feds balance sheet is a defacto tightening. The Fed may be reluctant to do both, i.e. hike, while also allowing the balance sheet to shrink too quickly. They could hike and do some re-investment, but it may be strange re-invest a large portion at the same time that they are hiking. I believe market turmoil and balance sheet maturities will cause a period of (hike) pauses in 2016. If this is true, Treasury market yields may not rise as high as some pundits are warning.
In a sense, markets are now beyond the control of the Fed. They were able to change investor behavior for a few years, but the herd mentality is now becoming dislodged: “lift-off” could possibly cause a steep reversal. I expect SPX to dip below 2000 by the time of the March 18th Fed Meeting. A ‘market reaction’ to pivoting policy is likely expected by the Fed, but SPX at 2000 would not enough to change its actions. How investors and asset allocators behave is the question.
Moreover, for stocks, rising bond yields will end the conversation about multiple expansion in US equities. Higher yields will also slow share buybacks, as corporate issuance to fund buybacks will dissipate. The shift in rate hike expectations is also accelerating the bid in the USD which will hit corporate earnings. Therefore, while equity prices and short maturity bonds prices could both fall, if the decline in equities falls too far too fast, then there would likely be flows into Treasuries until equities stabilize.
I expect the Fed to tighten in June and the Treasury curve to flatten. Carry and rolldown, relative yield attractiveness, the effects of ECB QE and the various other factors outline above and in prior notes will provide underlying support for Treasury prices. Should equities tumble too far too fast, all Treasuries yields across the curve would fall (and maybe materially) from today’s current prices.
Have a nice weekend.
-G
Guy Haselmann | Director, Capital Markets Strategy
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