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Yield
Economics – Markets – Strategy
US Treasury yields
are likely to rise
sharply
US: Bearish Treasuries
We believe Treasury yields will rise more than 100bps during 2H08. With improving
economic growth, inflationary pressures that may not be temporary, and increasing
bond supply, we are bearish on the US bond market, which we think will have
to discount substantial Fed tightening for 2009.
Much argues for a substantial sell-off in bonds. If the US economy picks up and
credit conditions improve in 2H08 and 2009, the Fed will have to remove the
policy accommodation that is currently in place with Fed Funds at 2% (see the
US economics section for details). We are confident that growth should improve,
thanks to:
a) continued noncyclical core consumption growth
b) relatively strong foreign demand
c) fiscal injections equivalent to 1.75% of GDP now coming on stream
d) a housing sector that will subtract progressively less from growth in the coming
quarters
e) lower interest rates
Moreover, there is the risk of an inflation psychology developing among consumers,
which suggests that even if the economy only grinds forward in the coming
quarters, the Fed might raise rates to prevent inflation from becoming an entrenched
phenomenon embedded in the economy.
Specifically, as growth improves to 2.5-2.75% (saar) in 2H08 and maintains at
this pace in 2009, we expect the Fed to hike Fed Funds by 50bps to 2.5% in 4Q08
and by 175bps to 4.25% in 2009. Fed tightening of this magnitude is not priced
into the yield curve, which means the front end will have to steepen if the
market comes around to the view that policy rates have to rise considerably.
Judging from recent history, 2Y yields could rise to 200bps above Fed Funds (i.e.
to 4%) in 2H08, before the Fed even starts to hike interest rates (Chart 1).
Chart 1: UST 2Y Yield - Fed Funds
%pa
bps
Chart 2: UST 10Y Yield - Fed Funds
%pa
bps
7
300
7
500
6
200
6
400
5
4
3
2
100
0
-100
5
4
3
2
300
200
100
0
1 Fed Funds Target Rate
UST 2Y - Fed Funds (RHS)
0
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
-200
-300
1
Fed Funds Target Rate
UST 10Y - Fed Funds (RHS)
0
Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06
-100
-200
Using the current regression relationship between 2Y and 10Y yields as a rough
guide, a rise in the 2Y yield to 200bps above Fed Funds (i.e. 4%) would put 10Y
yields at least 300bps above Fed Funds (i.e. to 5%), implying a flattening of the
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