2016 was the year when, in the aftermath of the Fed's first tightening cycle in a decade, the yield curve was supposed to not only rise substantially but also steepen, providing a much needed NIM arbitrage for commercial banks. That has not only not happened, but as a result of the Fed's relent according to which the Fed will no longer hike 4 times in 2016 but at peast 2, and according to the market 0, yields have tumbled.
Which brings us to a fascinating report by Citi's Vikram Rai in which the rates strategist tries to find if there is any upside to Treasury yields and is unable to find any. This is what he says.
More than 4 months have passed since lift-off and the first rate hike was largely transmitted to most money market rates (with T-bills rates being the occasional exception). But now, the prospect of another hike this year seems to be diminishing with the steady stream of underwhelming economic data, though Citi Economists believe that one more hike is likely this year.
While we await the next hike (whenever that may be), we search for factors which might influence yields higher in the short term markets. But, after examining the technicals in the G10 fixed income sector, this search seems like a fool’s errand.
However it is what Rai finds next that is absolutely stunning. According to Citi, the technicals that the report refers to are the rising proportions of negative yielding debt in the G10 fixed income sector; at present there is about $39 TR of outstanding G10 debt (Figure 3). Negative yielding G10 debt has jumped to $13.7 TR and accounts for 35% of all G10 debt. In this, the proportion of short-term debt is rising quite fast and about $2.6 TR of negative yielding G10 debt is in the 0 < 1YR sector.
As shown in the table above, Japan accounts for almost 58% of all negative yielding debt followed by France (11.33%) and Germany (10.66%). UK’s share of long dated negative yielding debt is disproportionately high due to inflation linked Gilts. And, TIPs account for all long dated negative yielding US debt because most short and intermediate maturity TIPs trade at negative real yields.
But here is why US yields are, if anything, set to decline more: on the other hand, the US accounts for almost 60% of all positive yielding debt and 89% of the positive yielding debt which has a tenor less than 1YR (Figure 4). Also, US debt accounts for 74% of the positive yielding G10 debt in the 1 – 5YR sector.
Thus, given that USD denominated debt is still extremely attractive vs. most high grade sovereign debt, we expect a structural increase in demand from foreign investors that are seeking refuge from a negative rate environment. And, given that USD debt accounts for most of shorter maturity positive yielding debt, the front end is likely to stay well supported and could richen further. But, despite these bullish technicals, we do not anticipate negative rates on short term USTs for now given that we do not expect that the Fed will implement a Negative Interest Rate Policy (NIRP).
While we agree with Citi, there is just one catalyst that could unanchor this inevitable increase in foreign demand for US paper (something we saw in the just released TIC data): a Fed surprise, where Yellen hikes rates despite the Fed Funds futures pricing in virtually no rate hikes until early 2017. That said, we doubt this will occur.