US: Dual tightening leads to higher nominal yields - BNPP

Analysts at BNP Paribas note that at her semi-annual testimony to Congress, Chair Yellen confirmed that the Fed is in no rush, but “expects the evolution of the economy to warrant further gradual increases in the federal funds rate.”

Key Quotes

“She also noted every FOMC meeting is “live.” Combined with very strong data, the probability of a 25bp hike at the March meeting has risen to 44% from 28% in a week and June is 78% priced in.”

“Yellen said the FOMC expects to unwind its balance sheet gradually when the process of normalising rates is well underway and keeping a larger balance sheet than pre-crisis levels may be desirable. Last week, we outlined our view on balance sheet reduction and expect it to begin in early 2018.”

“The 10y term premium could increase by 100bp over the next few years through ‘passive’ tightening, due to higher fiscal deficits (USD 800bn and  USD 1000bn in 2017 and 2018, respectively), resulting in higher Treasury issuance. Significantly increased issuance and a constant Fed balance sheet would cause a higher proportion of Treasury debt to be held by ‘private’ investors. Lagged by a year, this metric correlates with the 10y term premium.”

“While we expect balance sheet roll-off to begin in 2018, markets will likely begin to price the its impact on long-end term premia sooner. Therefore, the FOMC will likely embark on a tightening campaign at both the ends of the curve.”