The minutes of the US Federal Reserve’s December 14-15 policy-setting meeting were released on Wednesday, and their tone should have come as little surprise to markets given the magnitude of the pivot made by the Fed at the back end of last year. US growth remains robust, the unemployment rate is just 4.1% and likely to sink lower in the coming months. Friday’s non-farm payrolls jobs report could well surprise to the upside, so we wouldn’t be surprised to see unemployment actually dip below 4% in the next month. The US economy is therefore very close to full employment and consumer price inflation (CPI) is running at 6.8%, the highest since 1982. The conditions are clearly met for tightening to begin.
US Treasuries, however, are only just waking up to this fact and have been unusually slow to move towards higher yields. In the week before Christmas the yield on the 10-year UST was just 1.40%, and markets seemed happy that the Fed had finally made its pivot, reducing its risk of being behind the curve; the Santa rally could continue into year-end. However, since the start of this year the move higher in yields has been more aggressive as bonds have played catch-up to the news. The 10-year currently sits at 1.73% and risk appetite in all markets is waning because the Treasury move has been so sharp.
This all makes sense to us, and we would be surprised if this young trend does not persist longer – there is plenty of potential additional fuel to be thrown on this fire and we think markets have yet to price this in. The result in our view is that the Fed will have to move quicker and in greater magnitude than previously thought. Balance sheet reduction is likely to be on the cards this year already through non-investment of principal and interest on the Fed’s holdings, which sit at $8.8tr now.
The scale of excess liquidity in the market is at a level we have never seen before and this is causing all sorts of asset price inflation, spilling into the most obscure areas including even some luxury goods. Some $1.9tr of excess liquidity was parked with the Fed in its reverse repo at year-end, because there were not enough short term high quality assets available. The Fed was historically the lender of last resort, now it’s become the asset of last resort. Keep an eye on this number as it should fall swiftly this year, and it could have repercussions right across the markets.
Given the swiftness of the Fed’s pivot we think risks are tilted towards the central bank doing more and not less. We wouldn’t even rule out a 50bp rate hike at some point. It’s worth noting that 25bp increments have been the Fed’s tool of choice for the last 20 years, but for anyone currently debating whether a 1.73% 10-year yield looks high or low, it is easy to imagine a question about 50bp increments being put to Jerome Powell after the next Fed meeting on January 26-27. To be clear we are in no way calling a move to 50bp increments, but investors should be considering what isn’t currently priced in to markets today and this is one area where there could be some noise to come.
However, before we get too bearish, we are only 27bp away from 2% 10-year yields, and we think that is a level where a lot of investors would be looking to add exposure in meaningful amounts, which should lend some support.
From a bond strategy perspective the solution is clear; be very wary of duration risk, and from an overall risk perspective, we don’t think its time to be adding risk here as this story is only just starting to play out.