And another thing(s)...
A couple / few more observations from the sellside which came to my attention AFTER cobbling together and posting this update
2022 Outlook: Beyond inflation (Citi) where,
We expect a moderate rise in yields in 2022. The curve looks abnormally flat and more consistent, with mature stages of a tightening cycle rather than the cusp of one, and could be signaling growth concerns ahead. Inflation breakevens are likely to come under pressure, as we move past peak inflation
Cutting TO the chase, 2022 f’casts are for 2s up TO 1.40%, 5s up TO 1.75%, 10s up TO 2.0% and 30s all the way up TO 2.25% and as far as rates VIEWS go,
Duration: NEUTRAL (long 6m10y payer spreads)
Curve: Neutral 2s10s, flatter 10s30s (M2M5 steepener, 10s30s TIPS flattener, 1y CMS floor fly 10s30s)
AND as far as the somewhat longer-term goes … everyone’s fav 70s analog,
… Even over a longer period, including the high inflation periods of the 1970s, the 10y rate has generally headed higher over the course of the hiking cycle, as shown in Figure 5, which shows the synchronicity of fed funds and 10y rates. QE adds a twist this time compared to prior cycles, as the Fed is still providing stimulus via asset purchases primarily because it is worried about a tantrum on a full withdrawal. QE purchases are having a downward impact on yields, as we illustrate later on, but as these purchases are wound up by March, there will be more upward elasticity for yields.
Bonds are forward looking, and it’s possible that the market is discounting a slowdown ahead in global growth. This is somewhat hard to fathom because forecasts for 2022 US growth are still quite robust (~4%), and the labor market is still tightening. Global growth is projected by our economists to be 4.4%. But beyond 2022, the growth + inflation projections are less inspiring. One could point to potential pressure points, such as the property deleveraging in China, and of course the potential for the pandemic to cast a longer shadow via delayed re-openings and continued disruptions in supply-chain activities. The bond market did make a run for higher yields in November, getting close to 1.7% in 10s before the Omicron news hit, so in the counterfactual scenario of the absence of the Omicron variant, we might be in a higher rate world. But the reality of the pandemic persisting is hard to dislodge…
In as far as how all this forward looking winds up with a very consensus higher rates call,
We utilize our standard methodology for forecasting rates, which is based on three factors – lift-off period, pace of rate hikes, and terminal rate. For front-end rates, such as the 2y, the first two factors are dominant, whereas for the 5y and out points, all three come into play.
In our base case, we assume that the Fed hikes fed funds three times next year. In our base case, we pencil June as the likely lift-off date. At the end of 2022, with three rate hikes already in the bag, we assume that the market prices in a pace of about two rate hikes per year going forward, with a terminal rate pricing of 2%. Given the massive uncertainty around the pandemic variants, these variables may need attenuation over the course of the year. The terminal rate, of course, has a major impact on 10y and 30y. 2021 teaches us that the market is going to be reluctant to price the terminal rate much higher. The reluctance of the rates market to price in a higher terminal rate in 2021, except for a brief period in Q1, tips the scales in favor of 2% terminal rate pricing in our base case for year-end 2022. One significant reason why the terminal rate pricing continues to be depressed is the correlation with non-US terminal rates. This is evident when we plot 5y5y US against the first principal component of the 5y5y swap rates across the Eurozone, the UK, Canada, and Australia, as shown in Fig 10. Monetary regimes elsewhere exert influences across countries via capital flows and cross-border economic activity.
This gives us a 2% 10y target for year-end 2022 versus the current forward rate at year-end 2022 of 1.73%. The full yield curve estimates are in Figure 9. Our 2y forecast is in line with market forwards at 1.38%. The 5y is slightly higher – 1.75% versus the market pricing of 1.61%. We assume that the 30y trades at a lower premium to the terminal rate than it did in the past cycle. From December 2016 to December 2018, the 30y traded at an average spread of 55bp to the 5y5y OIS rate, with a low of 36bp and a high of 80bp. We assume that term premium in this cycle is much lower, and we use a 25bp premium to the 2% terminal rate, which gives a 30y forecast of 2.25% (versus a forward rate of 1.91%). In the bull case, we assume a terminal rate of 1.5%, two rate hikes in 2022, and one hike per year thereafter. For the bear case, we assume a terminal rate of 2.5%, four hikes in 2022, and two hikes per year thereafter…
Moving on to one other of Wall St’s popular kids final rates weekly of the year,
Cross Sector: The FOMC meeting made room for earlier rate hikes while the dots show the FOMC members are leaning into more hikes. Yet markets seem to want more. Balance sheet run-off policy is on the menu at the coming meetings, but it’s unclear if we’ll see it in 2022. A higher debt limit makes way for the TGA. Fed assets should normalize ~$8.9tn (until run-off begins), and reserves will contract as TGA grows.
Governments: Exceptionally negative real policy expectations and still-large Fed purchases are depressing yields. These factors point to higher yields in 2022, but short covering and weak liquidity could prevent yields from rising over the near term. TIPS appear cheap but the steepening of the breakeven curve has been justified.
Diving a touch deeper into JPMs ‘govies’ section, the bulleted points on USTs
The Fed statement and projections were largely in line with our own expectations, and the market reversal indicates either the press conference was more dovish or the market was braced for a more hawkish outcome...
…it was difficult to discern any dovish developments on labor markets, inflation or balance sheet in the press conference, and we think markets were simply braced for something more hawkish
Though nominal policy expectations have risen in recent months, real policy expectations remain exceptionally negative and along still-large Fed purchases, are keeping yields depressed. Both of these factors point to higher yields in 2022…
…however, we are cognizant that yields may not reprice higher over the near term, as uncertainty over Omicron remains high, investor positions still lean short, and liquidity has room to weaken further
We discuss lessons learned from trade recommendations in 2021: our curve and duration recommendations were largely profitable, but we were slow to recognize shifts in curve directionality, and we were too eager to identify the 20-year as cheap on the curve
October TIC data showed foreign investors sold $43.5bn long-term Treasuries over the month, the most since May. This largely emanated from the Cayman Islands, and likely reflected the hawkish pivot in DM central bank pricing over the month
With regards TO the FED, QE and supply to overwhelm demand,
… Moreover, even though the Fed has hastened its tapering and QE is expected to be complete by mid-March, the Fed continues to buy a 20% share of monthly duration supply (Exhibit 5). To an extent, the Fed’s tapering thus far has been offset by the cuts to auction sizes made in November, but its ultimate exit from the Treasury market should also be impactful on Treasury yields. We combine these factors in a framework in Exhibit 6 and find that these two factors have explained about 75% of the variation in 10-year yields over the last 7 years. The table shows that 10-year yields tend to rise about 45bp for each 100bp increase in real Fed expectations, and 10bp for each 10%-pt decline in the monthly Fed share of Treasury duration supply. Thus, given the empirical evidence we have, both our forecast looking for inflation to moderate over 2022 as well as the conclusion of Fed asset purchases by late winter support a move to higher yields in 2022.
AND some technicals backing up the higher rates call:
The 10-year note revisits 1.35-1.40% resistance that includes the 4Q21 pattern breakdown and Jul 61.8% retrace (Exhibit 3). The intermediate sector has traded in a broad range all year, defined by the 1.78% Mar yield high and 1.215% Jul yield low. In our view, that price action marks consolidation within an ongoing bear market. While repeated failures near the 1.35-1.40% resistance parameters represent our base-case outlook and would strengthen our conviction, a move back into the summer yield base would not derail our longer-term view. Secondary resistance sits at the 1.22-1.26% Aug-Sep range riches, and then the 1.125-1.14% Aug 2020 50% retrace/July yield lows. That multi-month trend reversal unfolded behind 0.95-1.00% 2020 yield base support. While the nature of how the US intermediate sector has traded in recent weeks has not triggered any of our systematic sell signals, bearish signals did trigger on the long-end charts in the US, as well as intermediate sectors in the EU and Australia. JGBs also are tracing out what appears to be a bearish reversal pattern after the Nov-Dec rebound. In our view, a 10-year note break through 1.54% Dec 8 yield high and 50-day MA would confirm a trend reversal and put the 1.69-1.71% fall cheaps back into view. Such a move would also move CTA signals back to negative in the month of Dec. We anticipate a backup to the 1.79% 2018 50% retrace in the early months of 2022, and expect the market to reach the next cluster of support in the 1.90s in the first half of the year.
Exhibit 3: The 10-year note revisits the 1.35-1.40% resistance zone as the market consolidates in the middle of the broader 2021 trading range. Bigger picture, we view that multi-quarter coil as a pause within a longer-term bear trend. A move through 1.54% would confirm a short-term trend reversal and put support in the 1.70s back into view. We ultimately expect a release to the next round of support in the 1.90s in the first half of next year
And meanwhile, rates over last couple weeks of the year are, so far, NOT playin’ ball.
More as / where possible and for now, off to the day job. Have a great start!