The Fed “shrinks its table ahead of schedule”, and the rise in US bond yields may be a little different this time. The minutes of the Federal Reserve meeting released in the early morning of Thursday (January 6, 2022) had a great impact on the market. The yield of 10-year US bonds stood at 1.70% again since October 2021. In addition to the expectation that the first interest rate increase will be advanced again (from May to March 2022), what has the greatest impact on the market is the remarks about early table contraction. “Interest rate increase + table contraction” may have a greater impact on the income of long-end US bonds: “Almost all participants agreed that it was appropriate to start the table contraction at a certain point after the first interest rate increase… Some participants said that it was appropriate to start the table contraction relatively faster after the first interest rate increase.”
This can not help but remind people of the situation at the beginning of 2021 – the mention of “taper” in the minutes of the Federal Reserve on January 6, 2021 also caught the market by surprise. After superposition, the US inflation exceeded expectations, and the 10-year US bond yield and US dollar index rose for a quarter, reaching a high point in the year. For the subsequent trend of US bond yield, we analyze it from the perspectives of policy and market logic:
In terms of policy, the Federal Reserve may start raising interest rates in the second quarter and give guidance on shrinking the table. The minutes have shown that “some participants believe that the current situation of the labor market has been largely consistent with the maximization of employment”, and the weight of the impact of changes in employment on the Fed’s monetary policy in 2022 has decreased. However, it may be too radical to start the contraction at the same time as the end of taper in March. The possible rhythm is to start raising interest rates in May or June and give guidelines for the contraction, In the second half of the year, select a month without interest rate increase to open the contraction table. (at the June 2017 meeting, the Federal Reserve gave guidelines for the reduction of the table, and the September meeting decided to start the reduction in October).
The Fed’s earlier and faster table contraction mainly supports the long-end US bond yield by limiting the flattening of the yield curve (the convergence rate of term spread). From the perspective of effect, the interest rate increase (expected) will mainly lead to the rise of short-term interest rate, but also narrow the term interest spread. Generally speaking, the direction of long-term US bond yield at the initial stage of interest rate increase is not clear. However, the reduction of the table will limit and slow down the convergence rate of term interest spread. In combination with the rise of short-term interest rate caused by interest rate increase, it will support the rise of long-term US bond interest rate.
How much room is there for the rise of 10-year US bond yields? Referring to the experience of raising interest rates since 2000, as well as the interest rates in the next two years (1.685% and 1.3%) shown in the dot matrix of the Federal Reserve and expected by the market, with the Federal Reserve starting to raise interest rates, it is a high probability event that the short-end us bond yield (represented by the two-year period) stands at 1.1%. According to historical estimates, under the contraction (expected), the term interest margin (10-year-2-year period) of three interest rate increases (0.75% increase in the federal fund target interest rate) may narrow by 30 to 40 BP. The emergence of the high point of term spread may focus on periodic re inflation transactions.
Since the beginning of 2022, the market has fluctuated greatly. In addition to the factors of the Federal Reserve, there may also be an important reason – after stepping out of the shadow of Omicron mutation virus, the re inflation trading logic began to heat up. The logic behind it is the staged economic recovery after the impact of the epidemic. The typical transactions are the steep term interest spread, the rise of real interest rate, the strong performance of crude oil in terms of commodities, and the good performance of banks and energy stocks in terms of equity, which is consistent with the market performance after the market gets rid of the fear of delta virus from August to September 2021. What do you think?
However, with the support of the post epidemic re inflation transaction, the market’s expectation of monetary tightening of the Federal Reserve in 2022 may go to extremes periodically, resulting in “overshoot” of US bonds. Referring to the market situation in the first quarter of 2021, in combination with the fact that U.S. inflation may peak in the first quarter of 2022, the expectation of interest rate increase will lead to the rise of short-term interest rate, and the expectation of table contraction may periodically limit the flattening of interest rate curve, which may lead to the volatile rise of long-term U.S. bond yield (nominal and actual) similar to that in the first quarter of 2021, The yield of 10-year US bonds may stand at 2% periodically, and the performance of the US dollar index is relatively strong, which is also in line with the performance of US bonds and the US dollar before the first interest rate hike in history. In this context, the volatility of the equity market will increase, and some institutional investors will wait and seek opportunities for low position building at the beginning of the year.
However, the phased expectation may not be enough to support the 10-year US bond yield, which remains high. Once there is expected to be a correction swing back, the market may fall to the US bond yield and the growth style will be favored. Refer to the situation in the second quarter of 2021. The trigger factors may be the spread of new strains, the faster than expected decline of US inflation at the bottom, the full expectation of interest rate increase and the cooling of contraction expectation, etc. When the liquidity environment begins to change marginally, this switching may be more frequent and volatile.
Risk tip: the epidemic spread exceeded expectations, and China’s foreign policies exceeded expectations
