Inflation or DE/DIS-inflation? Rotations. Yield curves steepening, flattening. Rebalance. Virus. Financial repression. TINA. FOMO. These are just a few of the many narratives asset managers are considering ahead of the turn of the year and kick off 2022. And with some/ many of these in mind, it would seem that most have agreed to a single outcome for the bond market — it’s dead money and rates are to grind higher no matter WHAT the view.
This in mind, the latest from a large German bank hit inbox last night and they say 10s are going to end 2022 @ 2.20 after hitting 2.25% in Q1 and 2.40% in Q2. With this higher yield CONsensus call in mind (and with such precision), I’m reminded of a saying of one of my former clients and good friend (of another less large German bank).
IF the majority were right, the majority would be rich.
Here is how they summarize
Treasury Market 2022 Outlook - Picking up the policy pace
The Fed has pivoted from supporting a broad labor market recovery to fighting inflation. However, the Treasury market is only at the beginning of pricing a new regime of rapid stimulus withdrawal and policy tightening. While front-end yields seem adequately priced for next year's rate hikes, longer-term yields are too low given expected growth and inflation. This is reflected by the low Treasury term premium and front-end real rates sitting 50-75bp below even conservatives estimates of r-star.
We forecast 10yr Treasury yields will rise to 2.25% in Q1 and 2.40% in Q2 next year. Our full set of forecast assumes the following:
The market pricing quarterly hikes from June 2022 until fed funds reaches 2.125%, with a modest term premium beyond that.
The UST 5s10s term premium correcting its full dislocation vs our model.
The UST 10s30s flattening on the back of pension flows, issuance cuts by the Treasury, and large convexity value at the long-end.
Swap spreads widening in intermediates and long maturities, but narrowing at the short end.
In this outlook, we deep dive into next year's Treasury supply and potential investor demand across major Flow of Funds accounts. We also discuss our TGA and swap spread outlooks, as well as detail our thoughts around quantitative tightening and its effects.
For 2022, we maintain a bearish bias for duration and favor trading steepeners hedged with higher short rates as an expression for higher term premium. We expect long-end yields to rise more slowly, leading to a general flattening of 30s versus 5s and 10s. In swap spreads, we favor wider intermediate and longer spreads and a flattening of the spread curve.
2022 Treasury yield and swap rate forecasts
Sounds simple enough. I’d point out one more excerpt/visual which I think especially relevant given the somewhat reduced probability for more stimmy (and so, more issuance?)
… For 2022, we forecast $1.50trn in Treasury net coupon issuance, a 44% decline yoy. Factoring the remainder of Fed purchases, net coupon issuance net of Fed is expected around $1.4trn in 2022, about 20% smaller than this year. In terms of duration supply, "net-net" coupon issuance is estimated to be around $2.3trn in 10yr note equivalents, a ~10% decline from 2021.
At the latest refunding meeting, the Treasury announced coupon cuts across the curve, reducing issuance by $84bn for the November-January period compared to the previous 3 months. We expect the cuts to continue well into 2022, with auction sizes stabilizing by August or November. For 2022's full year issuance, we’re forecasting a ~15% drop in the 10yr and 30yr, a ~24% drop in the 2yr, 3yr and 5yr, a ~34% drop in the 7yr, and a ~40% drop in the 20yr.
Larger cuts to the 7-year note and 20-year bond are needed to address the issues at those sectors. The 7-year sector saw the largest issuance increase during the pandemic, while the 20-year bond was grown to double what the TBAC had recommended for the initial auction size. The large auction sizes have contributed to their weakness at auctions and in secondary market trading.
AND as the story ALWAYS goes, supply is to overwhelm a market with diminishing official demand, so the result must always be higher rates, right? On DEMAND,
… Commercial banks … Regulators will have an important role to play in determining banks' appetite for Treasuries. The Fed could stoke demand by modifying the parameter of its standing repo facility to grant bank counterparties intraday access to liquidity. This would give Treasuries a more equal footing under certain regulatory treatments as reserves, which banks currently have a preference toward. Separately, modification to the SLR to exempt Treasuries would be very bullish for bank demand of Treasuries. However, given the current political climate, this is not our base case.
… Pensions … With pension funding status on the cusp of reaching full funding -- Flow of Fund data point to a 96% funding ratio as of Q3 and Milliman index suggests 98% as of November – further equity outperformance should lead to more aggressive de-risking and buying of fixed income securities. We anticipate net flows of $250bn-300bn for private and public pensions for next year.
States and local governments. Local governments bought more than half trillion Treasuries with the federal government stimulus transfers since the start of the pandemic. Next year, federal government transfers are expected to taper off while state spending should accelerate, as states and local governments will need to invest in public infrastructure projects as well as pay for ongoing public health responses and other benefit expenses. As a result, demand for Treasuries from this group could weaken considerably. We forecast net flows of close to zero for 2022.
And one last excerpt / visual since it was that JPOW mentioned foreign demand and relative (ie FX HEDGED) yield benefits — page 28 of 30 HERE,
… Foreigners. Through the first 9 months of 2021, foreign investors purchased $450bn in long-term Treasuries, exceeding every full-year total since 2012. Their demand was in part helped by the relative attractiveness of Treasuries against domestic sovereign bonds. Another factor might be the decline in bill supply had pushed them into buying longer-maturities. The establishment of the FIMA repo facility by the Federal Reserve may have also played a role by allowing foreign official institutions to monetize their Treasury holdings, helping encourage more buying. The Fed hiking faster than other central banks could increase hedging cost in 2022 and erode the attractiveness of hedged Treasury yields. Bill supply is also expected to rise next year. These factors suggest that foreign buying of long-term Treasuries could moderate somewhat next year, but demand still should be supported by a meaningful yield differential between US and other core rate markets. We forecast net flows of $250bn-300bn for 2022.
The entire note is only a few pages and again, concludes by paving road of logic which supports higher yield call.
I happen to disagree not ONLY because it seems to be the case that when everyone agrees on a certain outcome, well, usually something ELSE happens (Bob Farrell’s rules via stockcharts.com) — see Rule #9, “When all the experts and forecasts agree – something else is going to happen.”
I happen to think there is a NON ZERO chance of some sort of inflation rollover after base effects kick in (April / May). Lower inflation (ie transitory?) and an increased debt load we’re sporting around (stimmy x3) with much of what remains (infra) being only dripped in to the economy over several more years, a potential for fiscal TIGHTENING. This, combined with a QE morphing into QT (in pricing if not in reality, too) leading to an equity market accident.
When the Fed tightens and something breaks, there will be a rush TO a safety valve (USTs) and it will serve as another reminder 60/40 is NOT dead yet…
Just a thought but not one to take anything away from a bearish duration call laid out above.