The Fed has left little doubt that it will start tightening monetary policy soon and it seems to us that the latest data reports have further increased the pressure on the Fed to act soon.1
So far this year, the 10-year Treasury yield rose about 40 bps to just under 2%, which is still low by historical standards, as well as in light of high inflation and imminent Fed tightening.2
Swap forwards price in a rapid rise of short-term rates (Fed tightening) but very little for further increases in long-term interest rates over the next ten years (see Chart 1). The swap forwards imply that overall interest rate conditions remain broadly unchanged and that Fed tightening may push the economy close to recession (flat yield curve).
Source: Bloomberg3
We do not claim that the market is wrong. This note outlines our thinking on Fed tightening, the direct impact on Treasury yields and whether we will stay in the low-yield steady state of the last two decades.
Fed Chairman Powell stressed at the press conference after the last FOMC meeting that the economy is in a much different place compared to the last tightening cycle and that this requires an adequate policy response.4 The January labor-market and inflation reports have further underscored that view.5
The risk we see is that inflation remains stubbornly high and the Fed has to do more. But Fed Chairman Powell also talked about “two-sided risks” and the need to be “humble and nimble.”6 The memory of 2019 when the Fed had to reverse its tightening policy abruptly seems to be still present.7
We assume in our base scenario 200 bps of Fed funds rate hikes through the end of 2023, commencing in March with a possible first step of 50 bps and the chance of sequential rate hikes. Second, we assume the Fed will start rolling off maturing Treasuries starting in July. In our view, the Fed will limit the monthly Treasury roll-offs to $60 billion, which is double the cap from the last balance sheet reduction (see Chart 2). This pace would reduce Fed Treasury holdings by $925 billion by the end of 2023.
Source: Federal Reserve Bank of New York8
Our analysis suggests that Fed policy impacts the 10-year Treasury yield through three channels.
Source: Board of Governors of the Federal Reserve System and ZAIS calculations9
The net impact of our base scenario through the three channels would be a rise of up to 70 bps in the 10-year yield through the end of 2023, with a possible overshoot in 2022.
We see upside and downside risks to our base scenario of Fed tightening and, thus, the 10-year Treasury yield. Furthermore, the analysis so far assumes that all other factors that impact yields remain unchanged, especially those that have shaped the low yield environment of the last two decades.
In our view, higher savings and low long-term inflation expectations have been key factors responsible for the low yield environment of the last two decades. In 2005, former Fed Chairman Bernanke first talked about a “savings glut,”10 referring to the excess global savings that pushed into the US. Since the financial crisis, however, household savings in the US have also been rising (see Chart 4).
Source: US Bureau of Economic Analysis11
This rise in savings has been accompanied by low and stable long-term inflation expectations (see Chart 5).
Source: Board of Governors of the Federal Reserve System and Federal Reserve Bank of Philadelphia12
People are unlikely to save more if inflation expectations are rising. On the other hand, if people spend less and save more, inflation is unlikely to rise. The question is whether the steady state of high savings and low inflation expectations of the last 20 years will endure or if it is about to change.
Both survey- and market-based long-term inflation expectations have recently moved up but so far remain in the range of the last 20 years (see Chart 5).13 The household savings rate is declining after the surge during the Corona crisis but has not fallen below the levels before the Pandemic (see Chart 4 again).
We think that actual inflation will take time to decline and we also expect that savings may temporarily move lower. Our main scenario, however, is based on the view that long-term inflation expectations will remain anchored with a cap around 3% and that savings will stay elevated.
This base scenario rests on our view that Fed tightening plus the fading of Corona distortions and supply-bottlenecks will reduce inflation later this year and cap long-term inflation expectations. We also expect that the aging of the population will keep precautionary savings high and that the fiscal deficit will not offset private savings.14
If we are right, 10-year Treasury yields will probably move higher than what swap forwards imply but stay in the range of the last 20 years. Fed tightening would move the 10-year Treasury yield from the low-end of the range toward the high end of the range, which we estimate is around 3%.
If we are wrong, rising inflation expectations and falling savings would push the whole range higher and force the Fed to tighten even more. The risk of that happening is not marginal, in our view.
In a second note (Corporate bond and CLO spreads to diverge) we look at the impact of Fed tightening on credit spreads https://www.zaisgroup.com/corporate-bond-clo-spreads.html.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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