NN IP: Market has significantly reduced Fed rate expectations

As US government bond yields have declined, we have seen both a drop in the term premium and a decline in near-term Fed rate expectations. There has been a particular decline in further-out Fed expectations in futures contracts, as seen in Figure 1. The market currently assumes one further hike by the end of 2019. For 2020, the expected Fed rate is marginally lower than the current level. These market-implied Fed expectations are well below our own forecast, which is for one more hike this year and three next year. Since the peak this summer, market-implied expectations for the Fed rate at the end of 2019 and 2020 have dropped by 37 bps and 44 bps, respectively.

The drop in market-implied Fed rate expectations reflects the market’s worry that we are approaching the end of the cycle. It indicates a cyclical development rather than the ultimate neutral rate. Separating out the US 10-year yield into interest rate expectations and the term premium shows that the market’s opinion of the neutral rate has not changed much, whereas the term premium has dropped significantly. Figure 2 confirms that the rise of the US 10-year yield over the past years has been driven by long-term interest rate expectations rather than the term premium. The latter remains very low.

Investor positioning in US Treasuries is no longer extreme

We closed our underweight in US Treasuries in mid-October, when the 10-year yield was at 3.15%. A key reason was the extreme underweight position of investors in US 10-year Treasuries. Since then, these positions have significantly normalised, which has coincided with a sizeable 10-year yield correction. We view this as reason to re-enter an underweight position in US 10-year bonds. Not only has the investor positioning adjusted, but other supportive factors include a decline in Fed rate pricing (to below our own forecasts), a decline in the term premium and a decline in market pricing of long-term inflation expectations.

Over the past months, we have seen a significant drop in market-implied long-term inflation expectations. These expectations have declined on the back of various factors such as a drop in the oil price and market worries about the economic outlook. We responded to this last week by increasing the allocation to US inflation-linked bonds relative to US nominal bonds. The underlying inflation trend and our constructive view of oil should enable a rise in market-implied inflation expectations, especially in the US.