As noted on Thursday, there’s a tug-of-war developing between two competing narratives on US Treasurys. Here’s what we said yesterday:
On one side are those who, like Bloomberg’s Mark Cudmore, believe that the Fed’s messaging on Wednesday conveyed a cautious outlook on the economy thus telegraphing “much more to come” in terms of falling yields and USD weakness.
On the other side are those who are sticking with the reflation story and hanging on to the idea that dissipating political risk following an assumed loss for Marine Le Pen in the French elections combined with a more benign outlook on global growth and inflation will ultimately mean long-end rates are likely to move higher.
If you’re in the camp that thinks the Fed might be a little surprised at the market response and thus a little leery of the fact that because equities rallied and the dollar slumped financial conditions actually eased following the hike, will appreciate Barclays take on the subject.
It’s pretty simple really. If the Fed plays catch up the straightforward way (i.e. with aggressive messaging and FF hikes) and puts off SOMA rolloff to another day (read: another year), then you’ve gotta think flatteners are the way to go in the near- to medium-term.
With that in mind, consider the following.
The market response to the March FOMC meeting likely strengthens the case for more regular hikes since financial conditions actually eased. We continue to recommend being in 3s10s curve flatteners because we believe the markets are being too sanguine about the path of the hiking cycle and are overly worried about balance sheet reduction. We are turning neutral on our outright long 10y UST view, given the reduction in short positioning, and prefer to express the long duration view as a convergence trade between US and UK 10y yields, outright and conditionally via 6m30y receivers.
The Treasury market outperformed its global counterparts over the week despite a Fed hike and reduced political uncertainty in the euro area. The March FOMC meeting was perceived as dovish as investors were likely looking for the Fed to signal the possibility of four hikes this year or at least indicate the possibility of balance sheet reduction later in the year. Short covering also likely exacerbated the rally. Meanwhile, the Dutch elections resulted in a Eurofriendly outcome with preliminary results showing the incumbent VVD party significantly outperforming Geert Wilder’s PVV. Similarly, the market-implied probability of Marine Le Pen winning the French elections have also declined. Figure 1 shows that real yields fell sharply in the US while rising in the US and UK, reflecting these developments.