Up to an $800 billion negative shift in the demand-supply balance for US Treasuries – could the US yield curve actually steepen?
9th June 2017
Historically, in periods of monetary policy tightening by the US Federal Reserve (Fed), the US yield curve has flattened and eventually inverted as shorter-dated US Treasury yields rise more than longer-dated Treasury yields.
This flattening and then inversion of the yield curve has always led to recessions as banks curtail lending to the real economy due to shrinking net interest margins; banks make money by borrowing short and lending long-term. This phenomenon causes a contraction in the extension of credit and slows the economy.
Question: What factors will distinguish the current Fed hiking phase from previous policy cycles?
Answer: Fiscal stimulus (tax cuts and infrastructure spending) combined with an unwinding of the $4.5 trillion US Fed Balance Sheet should steepen the curve, and may perpetuate the economic cycle.
Question: Why should yields rise and the curve steepen?
Answer: Less demand and more supply.
Up to an $800 billion shift in the demand-supply balance for US Treasury Bonds caused by
1. A shift in net demand due to the Fed ceasing purchases (Quantitative Easing) and not re-investing maturing bonds.
2. A greater supply of longer-dated US Treasuries to pay for US infrastructure programmes.
The author is of the view that the Federal Reserve is likely to stay behind the curve in the medium-term with regards to policy rate hikes – shorter-dated Treasuries should remain supported. Also, the potential for a sizeable fiscal stimulus package from the Trump administration is being underestimated by the market. The reflation theme evident across the global markets since the summer of 2016 remains broadly intact.
Sam Hogg and Brian Tomlinson
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