Divyang Shah, Senior IFR Strategist
1) The discussion over the timing of Fed tapering QE, and
2) A 50bp move higher on 10-year yields since the payrolls release on May 3.
We have also seen some longer term investors start to cut weightings on what they believe to be overvalued bond markets expecting less manipulation as QE is tapered.
The uncertainty over timing of tapering and eventual end to QE remains uncertain and likely to stay in a state of flux over the coming months but the ultimate direction is clear. The Fed’s desire to take the foot off the accelerator and let monetary policy coast at a high speed is understandable.
We have looked to play this via a 2s/10s steepener which at the current level of 187.5 is well in the money compared to our entry of 170bp. But the road to our ultimate target of 280bp is going to be long and volatile.
What is interesting so far is that the Fed has done little to raise eyebrows and are likely happy that risk markets are in less exuberant form.
Given the experience with 1994, the Fed will look to manage expectations in such a way as to have greater control over the pace at which financial conditions are tightened.
The current stage is about preparing the markets for various eventual scenarios and the bond markets are doing just that.
What will prevent Treasuries from becoming too much of a headache for the Fed is that this should involve tapering/ending QE as opposed to a real tightening of policy through a shrinking balance sheet and higher interest rates.
The lag between taking the foot off the accelerator (tapering) and tapping on the brakes (higher interest rates) suggests maintaining a bias toward curve steepeners.
