research conclusion
So far in the normalization process of the Fed’s current round of monetary policy, taper has just started, and the interest rate increase has not been started. However, under the environment of high short-term interest rate and weak long-term interest rate, the flattening trend of interest rate curve has continued to develop. As of December 30, 2021, 2s10s US debt term spread was 77bp.
With the advance of the interest rate increase cycle, the term interest rate spread tends to narrow rapidly, while the upside down of the yield curve seriously hinders the normal operation of the financial system and indicates the risk of recession and market turmoil. Therefore, it has become the heart and soul of the monetary authority. In the last round of interest rate hike cycle, the Federal Reserve once chose to suspend interest rate hike and cut interest rates instead in the face of upside down pressure (2019).
How to understand the flattening of the current US bond yield curve? How does the Fed seek change? What impact may it have on the process of this round of monetary policy normalization? We will conduct a preliminary discussion in this report.
The short-term interest rate has steadily strengthened, and the action on the long-term interest rate is insufficient: since the middle of the year, the short-term interest rate of US bonds has been steadily strengthened supported by the expectation of interest rate increase, and subject to the cooling of long-term economic growth expectation after the epidemic and the peak after the rise of inflation expectation, the yield of 10-year US bonds fluctuated in the same period, and seems to be subject to the tightening expectation of monetary policy. At present, the interest rate increase has not been started, and the term interest margin has been consumed to the level of early 2018.
The term interest spread may continue to narrow: on the one hand, the operation of short-term interest rate will largely reflect the change of spot policy interest rate in the future. As the interest rate is approaching to increase, the probability of short-term interest rate level will rise synchronously with the policy interest rate. On the other hand, the level of long-term real interest rate has always remained in the negative range, the implied inflation expectation fluctuates at a high level, and the nominal interest rate is flat as a whole, which confirms that it is difficult for the current long-term economic growth expectation and inflation expectation to continue to rise. The sharp contraction in the net supply of US bonds will also form an asymmetric suppression on the long-term interest rate trend of US bonds.
The choice of the Fed’s monetary policy: facing the disadvantage that the space is narrowed and the long-term and short-term interest rates are still running in both directions, the normalization path of the Fed’s current round of monetary policy may not evolve according to the consensus expectations of the current market. In the future, the Fed may need to make active policy choices. The core logic is to seek adaptation in the short end or space in the long end.
Option 1: adjust the rhythm and range of interest rate increase. The current situation of term interest margin does not support substantial and continuous interest rate increase. Historically, the current period interest margin has fallen to the current level. The average number of remaining operable interest rate increases is 5.5 times, and the rate increase range is about 1.5%. This means that even if the current interest rate increase cycle starts, it may be short and hasty. In addition, the necessity for the fed to raise interest rates depends on the inflation trend. We predict that the peak inflation in the United States will fall in 2022, giving the fed the freedom of decision-making in raising interest rates. In this case, the long-term and short-term interest rates do not have the momentum to continue to rise sharply. The monetary policy is obviously pigeon compared with the current consensus expectation of the market, which will be good for the risk assets with the US bond interest rate as the pricing anchor, and may bring gold allocation opportunities due to the reversal of policy expectations.
Option 2: start the balance sheet instrument in advance (shrink the table). Or the table contraction needs to be started early to cooperate with the interest rate increase cycle to form a synchronous upward pattern of long-term short-term interest rates with a closer slope. Historical experience shows that the table contraction may be more effective in driving the long-term interest rate and even widening the term interest spread. The impact of the scale reduction on the supply and demand of long-term US bonds is much stronger than taper: after the scale reduction was launched in 2017, the yield of 10-year US bonds rose significantly in the same period. From the current balance sheet structure of the Federal Reserve, during the epidemic period, the Federal Reserve increased its holdings of about 3.3 trillion US bonds, of which the growth of short-term US bonds was 0, and the growth of medium and long-term nominal US bonds was 2.9 trillion. When the balance sheet reversal enters the contraction cycle, the Fed has reason to believe that its operation will drive the sharp rise of long-end US bond yields. In this case, the long-term and short-term interest rates will rise simultaneously, and the sharp rise of risk-free yield may become a key variable affecting the market trend in the future.
Risk statement
The short-term interest rate was suspended upward, and the term spread widened again.
The long-term interest rate is affected by factors other than the Fed’s monetary policy.
