USD Rates: From inflation to hawkish central banks to growth worries

Unwelcome mix of high inflation and hawkish central banks.
Eugene Leow28 Oct 2021
    Photo credit: Unsplash Photo

    Overnight, 10Y and 30Y US Treasury yields fell below 1.6% and 2.0% respectively as market participants ponder the unwelcome mix of high inflation, tightening central banks and the potential for slower growth. The rapid frontloading of rate hike expectations across the globe is starting to unnerve investors. Yesterday’s decision from the Bank of Canada to cease quantitative easing and pull forward rate hike expectations into mid-2022 exacerbated these dynamics. 

    The rise in USD rates over the past two months has one big difference from the period in 1H when rates were similarly rising. This can be shown by looking at the longer-term implied real rates (we define that as 5Y5Y inflation swap less 5Y5Y SOFR OIS). In 1H, while inflation expectations (5Y5Y inflation swap) did rise, this increase was considerably more muted than the jump in in 5Y5Y rates to 2.36%. As a result, 5Y5Y real rates closed in on zero, from around -1% at the start of the year. Comparatively, 5Y5Y inflation swaps have now pushed to 2.65%, well above the 2.55% high registered in May. However, 5Y5Y SOFR OIS is still only at 1.66%, placing the implied 5Y5Y real rate at close to -1%, too low in our opinion. 

    While the market was too aggressive in factoring in higher longer term real rates in 1H21, we would argue that the opposite may be true now. We would reasonably expect 5Y5Y real rates to be much closer to the -0.5-0.0% range (a conservative take on where neutral should be), assuming that the Fed will be largely done with tightening in five years.  Inflation swaps clearly display worries that inflation is not transitory, pricing inflation well above the Fed’s symmetrical 2% target beyond five years. Unless growth turns structurally lower than 2%, we are sceptical that the Fed would stay that dovish in an elevated inflation backdrop. We reckon that 5Y5Y real rates would rise, possibly by a combination of higher nominal yields and perhaps slightly lower breakeven.

    Our overall strategy for USD rates has not changed. We think overall bear flattening (a view we have held since late June) is taking place, with upward pressures on yields more acute in the 2Y-5Y segments. However, we are starting to lean against the pace of flattening that has taken place over the past few trading sessions. There clearly is some wariness on growth in a tighter monetary policy environment but we suspect that higher short-term rates will eventually be digested by the markets if growth proves steady. We are wary of longer-term US Treasuries after the recent rally, noting that 10Y yields is close to the bottom of the pre-pandemic 1.5-2.0% range which we define as normal. Similarly, 30Y yields at 1.95% is below our long-term fair value floor of 2.0%.These levels are starting to look interesting for tactical pay opportunities.

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
    [email protected]

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