As we noted this morning, despite the coming fiscal gridlock, December rate hike odds actually increased this morning ahad of the Fed's policy decision tomorrow, with two more hikes still priced in for 2019, even as both equity and rate volatility tumble in unison. Meanwhile, despite the sharp decline in rate volatility, the recent stability in the bond market is not seen as lasting long, with a confluence of factors converging to impact the "most important" catalyst behind this year's instability in risk assets - the 10Y yield - which will likely continue rising after the current period of calm.
There are several reasons for that, among which:
- Supply Concerns: With the US set to issue over $1.3 trillion in new debt in calendar 2018, investors not only have to digest record-sized Treasury auctions, but accept that much more borrowing is to come. In fact, as some have speculated, a House led by the Democrats raises the specter of possible infrastructure spending, and President Donald Trump has indicated he may be willing to work with them on that. On top of that, recent government bond saleshave already shown signs of weakening demand.
- Fiscal Deadlines: As Bloomberg noted this morning, money-market traders are bracing for face bouts of volatility as fiscal deadlines loom even larger now, with the next one on deck just one month from now, when on December 7 spending authority under the current continuing resolution comes to an end, threatening another potential government shutdown. After that, the biggest risk next year is for a protracted battle over the debt ceiling.
- The International "Diversion": Amid the concerns laid out by some European analysts, Trump’s more limited room for domestic maneuvering could provoke the president to focus on international affairs by intensifying the trade war. That could spur further swings in the Chinese yuan and emerging markets, which could in turn affect U.S. assets.
To be sure, today's "dismal" 30Y auction already showed that something is not quite right with the bond market when the sale of $19BN in 30Y paper clearly stunned the bond market, and instantly repriced the long end higher in a harbinger of what may be in story in the coming months.
So what happens next? Below is a summary of some of the more notable sell-side views laid out this morning, courtesy of Bloomberg:
- “The midterms are unlikely to have a significant bearing on the economy,” Capital Economics U.S. economist Andrew Hunter wrote in a note. “But they probably raise the risk that political uncertainty once again becomes the dominant theme over the next couple of years.”
- “The results of the election shouldn’t change the immediate path of the economy or monetary policy,” independent strategist Marty Mitchell said in a note, citing the Trump administration’s already implemented fiscal initiatives. “For these reasons, the Fed will continue to lift the fed funds rate and the U.S. yield curve should maintain an upward bias going forward from here.”
- NatWest Markets strategist John Briggs suggests fading the long-end buying in Treasuries, because once the dust settles, market movements will be “more muted” and quickly refocus on the underlying fundamentals and upcoming events. Briggs also said political gridlock may give way to increased spending. “When it comes to budgeting, the only way to agree on a budget may be to give candy to everyone, and spend more rather than less,” he said.
- “Trade uncertainties, investigations and impeachment threats are downside risks,” Dana Peterson, an economist at Citigroup, wrote in a note. “The persistence of U.S. trade disputes with other economies, including China and the EU poses downside risk to global (and ultimately U.S. growth) via trade, confidence and inflation channels.”
- Going forward, the removal of uncertainty and realization of the expected outcome should be supportive for risk assets, the yield curve returning to a more normal flattening pattern, and a modestly weaker broad dollar, Goldman Sachs analysts wrote in a note.
- “With election results in hand and largely in line with expectations, the bond market quickly looks ahead to Thursday’s FOMC announcement,” said Colin Lundgren, global head of fixed income at Columbia Threadneedle Investments. “ No rate hike expected this month, but investors will be looking for language in the statement that highlight the Fed’s concern for changing financial conditions, and potential impact on future policy decisions.”
- Finally, focusing on the yield curve shape, Wells strategists including Mike Schumacher still expect the Treasury curve to bear steepen by the end of 2018 and into 2019, resulting in more vol on the long end, given midterm election impact on the U.S. bond market typically fades within a week and supply remains heavy. Plus, there’s “little link between Congressional control and spending,” suggesting that for all the posturing, yields may simply continue going up amid concerns for "double deficits."