Traders are placing bets on the U.S. government bond yield curve to steepen ahead of the conclusion of the Federal Reserve’s two-day meeting on Wednesday, even as global growth fears keep interest rates capped.
Perhaps more so than economic optimism, analysts said such wagers could partly reflect short-term trading strategies around expectations for the Fed to signal tweaks to the central bank’s balance sheet runoff process. Traders are simultaneously buying short-dated bonds and selling their longer-dated peers to profit from an early end to the Fed’s normalization of its $4 trillion portfolio this year, which could widen the spread between short-dated yields and long-dated yields, an indicator of the yield curve’s slope.
With the Fed most likely capitulating on balance sheet runoff next week, the curve is in a steepening mood.
— Ed Bradford (@Fullcarry) March 14, 2019
See: Fed seen revealing ‘how and when’ it will stop shedding balance sheet assets
The yield spread between the 5-year Treasury note TMUBMUSD05Y, -0.14% and the 30-year bond TMUBMUSD30Y, -0.01% the most frequently traded pair for bond-market speculators betting on changes to the yield curve’s slope, stood at 61 basis points on Monday, up from 51 basis points at the start of the year, Tradeweb data show.
Much of that widening has come from the sharper slide in yields on short-dated Treasurys relative to their long-dated peers. The 5-year note yield has retreated more than 60 basis points to 2.41% since its November peak, while the 30-year bond yield pulled back by a more modest 40 basis points to 3.02% over the same stretch. Bond prices move inversely to yields.
Considered a warning sign of looming economic stress, a flattening yield curve can point to dimming expectations for growth, while a steeper curve could signal mounting expectations for an uptick in growth and inflation. A steeper yield curve, however, doesn’t necessarily point to a sunny economic outlook. The recent retreat in long-term yields, albeit at a slower pace than the fall at the short end, suggests bond market traders see reduced prospects for U.S. growth, said analysts.
Following the central bank’s pursuit of a more patient policy path on interest rates in January, investors have awaited a similar shift on its crisis-era portfolio. Senior Fed officials said they were open to tweaking how they ran down their $4 trillion-sized balance sheet if its reduction presented a problem, appearing to backpedal from their long-held position that the shrinkage of the central bank’s portfolio was on “autopilot.”
Since October 2017, the Fed has allowed assets on its balance sheet to roll off at a fixed monthly pace by declining to reinvest the proceeds from maturing bonds and mortgage-backed securities. The reduction reached a maximum pace of $50 billion per month last October, drawing concerns it had tightened financial conditions and amplified market volatility at the end of last year.
Read: Here’s the debate over whether Fed’s balance-sheet runoff is slowing the economy and stoking volatility
But in a sign the Fed was ready to break from its autopilot stance, the minutes from the January Fed meeting said “almost all [FOMC] participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”
If the Fed signals a premature end to its balance-sheet reduction, analysts point to a number of ways long-dated yields may surge and steepen the curve.
For one, analysts at Nedbank say any hint from the Fed that it intends to halt the shrinkage of its crisis-era portfolio could boost liquidity and stir a rally in risky assets such as equities. That, in turn, should dampen demand for haven assets like long-dated bonds, lifting their yields.
After all, when the Fed decided to stay on hold at its January meeting, equities rebounded sharply from their December selloff. The S&P 500 SPX, +0.37% is up nearly 13% year-to-date, though the broad-market index has yet to reclaim its record high, FactSet data show.
Moreover, a dovish tweak to the balance sheet runoff would represent a key signal of the Fed’s willingness to ease up pressure on the economy. The more patient policy could thus give growth and inflation room to stage a steady comeback, a bearish scenario for extended maturity Treasurys. Price pressures tend to weigh on fixed-income payments for longer-term bonds vulnerable to the corrosive impact of inflation.
“If the Fed does maintain a dovish bent, it will give more of an inflation premium and push long-end yields higher, steepening the curve a bit,” said Shweta Singh, managing director for global macro at T.S. Lombard, in an interview with MarketWatch.
Investors say potential tweaks to the portfolio reduction process could also cause yields for front-dated bonds to fall, and thus steepen the yield curve’s slope.
One of the widely discussed possibilities is for the Fed to end the runoff of the Treasurys portion of its portfolio this year while allowing the rolloff for its mortgage-backed securities to continue unabated. The Fed would then deploy proceeds from the maturing mortgage bonds into shorter-dated government paper, pushing their yields lower, according to Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.
But others say bond traders could be setting themselves up for disappointment.
Ward McCarthy of Jefferies said given that the central bank had yet to publicize any research on what constitutes a normal-size portfolio, it was unlikely to provide new details on its plans for the runoff.
Providing critical information for the U.S. trading day. Subscribe to MarketWatch's free Need to Know newsletter. Sign up here.
