Let the US yield curve guide - viewing the 2s v 5s UST curve

8 Oca 2022

As we approach a world where the Fed look set to hike in March, with 3.4 hikes priced by Dec 2022- we are also now hearing an open discussion around allowing maturing securities on its 8.8t balance sheet to run off (QT) -so, it's worth going back to the Dec FOMC minutes for real insight.

With the market having had time to pour over the wording, it feels clear that the key paragraph is the one highlighted on the chart - with the Fed saying that history has not been so kind when hiking into a flatter curve.

This suggests that if the curve does head towards inversion - and I've chosen the 2s v 5s - then the Fed will do its utmost to counter that - this suggests:

1) the Fed desire a steeper yield curve
2) will favour QT/ balance sheet run-off if we see a flattening curve

In the situation of continued high inflation, wage pressures and full employment, the Fed now have maximum optionality, but to counter the impact of higher fed funds on demand, utilising its balance sheet could be the key focus over hikes.

So our central guide on the Fed's thinking will be the yield curve...and judging by the FOMC minutes if this is flattening and headed towards inversion, the lessons of 1986, 1988, 1999, and clearly 2006 are our case study by which we can wok with.

So if the curve steepens and heads to 1%, the Fed will be compelled to hike concurrently with BS run off... but should if flatten then rate hikes will be priced out - This should offer excellent trading opportunities to go long US 2year Treasuries, and US rates (fed fund and ED futures) and may weigh on USDJPY initially before the market puts more weight on future relative balance sheet differentials. Gold should rally on a flatter curve.

CW