SPDR ETFs: Fed and BoJ – The World Was Flat…It’s Getting Steeper!

Sep 20th, 2016 | By | Category: Fixed Income

By Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA, State Street Global Advisors

SPDR ETFs: SSGA examines yield curve strategies ahead of Fed and BoJ policy meetings

Antoine Lesné, Head of SPDR ETF Strategy & Research EMEA.

It seems some time since we last wrote about ‘bond vigilantes’. But here we are. The important date of 21 September is approaching at the speed of light and some commentators are calling for ‘the big one’. A surprise rate hike? Japanese taper? More negative rates? The return of inflation? There is a lot of headline risk going into this meeting. In this note, we look at what has happened from a US rate standpoint and which part of the curve could be most interesting to target.

From Flat to Steep? Not So Fast

The summer was quiet. But now we’re back to school and yield curves have started to steepen. With bond vigilantes, negative interest rate policy (NIRP) and QE efficiency in question, the Bank of Japan (BoJ)’s Kuroda and US Federal Reserve (Fed) members have managed to create something of a wake-up call after a relatively calm summer. Boston Fed president Rosengreen recently argued that the market was under-pricing the outlook for rates.

All in all, even though the US curve has steepened a bit it may still be too early to call time on this year’s rally. We have to remember that curves had rarely been that flat. So, steepening is a normal process given where we have been. The 10-year US Treasury yield has increased 11bps to 1.69% month to date, but is still down 58bps versus the 31 December 2015 level.

Source: Bloomberg Finance, SSGA, as of 16 September 2016.

Source: Bloomberg Finance, SSGA, as of 16 September 2016.

21 September – the Day of the Central Banks

These developments in the US yield curve (and other developed markets) have reduced the amount of negative-yielding bonds across global bond indices. However, this week we have two of the largest central banks in the world announcing their monetary policy. Could we see further easing and/or tapering in Japan? Will there be no hike in the US but signals for December plans? We believe that the two are interconnected and much depends on the BoJ, too.

20-21 September:  the Bank of Japan

The BoJ will start a two-day meeting on Tuesday with a full agenda to discuss monetary policy and assessing NIRP and QE effectiveness; going into this meeting, options remain open.

– Rate cut: a potential cut from -10bps to -30bps depends on how efficient the BoJ believe such a strategy will be. The main impact from this would be to steepen the Japanese yield curve and weaken the currency. While the former may be effective, as we saw in January it did not change the strengthening trajectory of the Japanese currency.

– Asset purchases: like in Europe, the bond scarcity issue has to be discussed and the result could be a reduction of JGB purchases from the current JPY 80trn per year to a lower level (estimates of JPY 40trn) to twist the curve and steepen its long end.

The risk from this meeting is that it could feel like the beginning of tapering in Japan despite assurances from the BoJ’s Kuroda that stimulus should remain.

21 September:  the FOMC and the Infamous Dot Plot

Fed Fund Futures point to very low probability of a rate hike on Wednesday. More hawkish comments after Jackson Hole revived the September hike probability to 44%, but lower-than-expected nonfarm payroll figures and mixed economic data have brought probability back to less than 20% at the time of writing. A hike, if it were to happen, would thus come as a surprise. The tone of Fed Chair Janet Yellen’s speech will remain key, and hints – such as optimism concerning the economy – will be monitored.

The expectation is that Yellen will keep a December hike alive, although the path may remain gradual – more gradual than the ‘Dot Plot’ is showing. Core CPI was up 2.3% in August from 2.2% the month before; this is not sufficient to justify an imminent rate hike but important to the pace of future rate hikes.

The fact that these two events coincide has resulted in a recent link between the strength of the JPY and evolution of the 10-year US Treasury yield (i.e. stronger yen, lower US 10-year yield). That correlation started to weaken in late July but has accelerated since Jackson Hole (see figure 3). This is a trend to watch, especially if the long end of the Japanese curve steepens, offering positive yields to domestic investors and thereby weakening the foreign buying support for US treasuries.

Source: Bloomberg Finance, SSGA, as of 16 September 2016.

Source: Bloomberg Finance, SSGA, as of 16 September 2016.

How to Position? Playing it in the 5-10 Year Sector

These two central bank meetings have the potential to surprise investors. Whether your outlook is for surprising words from the BoJ on “taper” or digging deeper into negative rates, or you expect no move from the Fed but a hawkish speech, there are ways to position your portfolio in the US Treasury market. By focusing on the steepest part of the curve, namely the 5-10 year horizon, investors could position themselves around the 5-7 and 7-10 year parts to come into the meeting slightly underweight or overweight duration versus the broad US treasury index.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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