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MACRO VIEW COLUMNS: Bond Markets Contemplate the Terminal Funds Rate

(Bloomberg) — The big Fed meeting has come and gone, and generally speaking there has been little notable reaction from the bond market. Yields remain exceptionally low by historical standards, but despite this curves continue to flatten. Does this suggest that investors fear that the Fed is on the precipice of a policy mistake? Not quite — while the market view of the terminal Fed funds rate remains exceptionally low, there are other factors depressing the level of Treasury bond yields. In any event, market history suggests that we still have a ways to go before the end of the Fed’s tightening campaign.

  • For the moment it seems laughable that the Fed was ever worried that a shift in the balance-sheet policy could spark market volatility. U.S. 30-year yields are almost exactly where they were on Monday, and just 3 bps above levels prevailing a month ago
  • Still, one clear trend is that the U.S. yield curve continues to flatten. The 5s30s curve is at its flattest level since late 2007 and 2s10s is also hovering just above key support. Does this reflect a market concern that the Fed is approaching the end of its policy cycle already?
  • To a degree, the answer is yes. Looking at one-month OIS swaps five years forward as a proxy for the market’s estimate of the terminal funds rate, we find that it’s pricing rates a little below 2%. That’s well below the Fed’s own estimate of the long-term policy rate, but the spread is closer than it’s been for much of the time that the Fed’s been making forecasts
  • Still, it’s important to recognize that there are other factors that influence bond market pricing, at least in the short run:
    • The low level of European yields continues to drag Treasury yields down. A 10y Treasury premium of 1.8% over Bunds is pretty tasty when the latter yield is less than 0.50%
    • Regulatory pressure to own HQLA. Banks need to keep a higher percentage of Treasuries on their balance sheets than was historically the case. Given that central bank reserves are also HQLA, as the Fed winds down it’s balance sheet banks may be forced to buy the bonds that the Fed doesn’t
    • For the time being at least, they’ll have company from FX reserve managers. This year Fed custody holdings have risen $20 billion/month, a sea change from the decline of $5 billion/month in 2014-16 a reversion to the historical average of the 2004-07 “conundrum” era.
  • In any event, there is some ways to go before calling the end of the tightening cycle. The yield on the 20th eurodollar contract (ie, 3 month Libor approximately 4 years in the future) remains comfortably above the policy rate. The prior two easing cycles didn’t begin until ED20 traded through Fed funds
  • That’s still well more than 100 bps away, so there’s ample room for the Fed to keep on truckin’. In all likelihood that will eventually nudge Treasury yields higher
  • NOTE: Cameron Crise is a macro strategist who writes for Bloomberg. The observations made are his own and are not intended as investment advice.

To contact the reporter on this story: Cameron Crise in New York at ccrise6@bloomberg.net

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