USD Rates: The Fed’s shifting tone and rates implications

We lay out strategies to handle high inflation and Fed taper.
Eugene Leow17 Jun 2021
  • The USD curve should steepen into the leadup to taper
  • Once taper is hinted, the back of the curve should flatten
Photo credit: AFP Photo

Overnight, the US Federal Reserve’s Open Market Committee, recognising strong growth and rising prices, pulled forward projections for rate hikes. Projection for real GDP growth for 2021 was revised to 7% (from 6.5%) and kept to well above 2% in the subsequent years. Similarly, core PCE inflation forecast was raised to 3.4% in 2021, from 2.4% previously. The subsequent two years saw 0.1pct-pt increase to 2.1% and 2.2%.

Forward guidance from the Fed proved to be more hawkish than what the market expected. Prior to this meeting, there was no communication that the Fed would be satisfied with the pace of labour market improvement or that the price pressures would prove anything but transitory. This meeting changed that with Fed Chair Powell acknowledging that inflation could turn out to be “higher and more persistent than we expect” while also expressing confidence that the economy is “on a path to a very strong labour market.”

In terms of dot plots and taper, the Fed was also a tad more assertive than what we had expected. 11 FOMC members are now looking for 2 hikes in 2023, with 7 seeing a hike as early as 2022. In March, the median was for a hike to begin only in 2024.

Chair Powell also stated that discussions on taper is starting, putting August / September as the key period where plans could be announced. Given that a significant number of Fed officials see rate hikes in 2022, we can infer that the pace of asset purchase reduction could prove to be faster than what we saw in 2014 (spanning 12 months). Assuming that the Fed starts taper in end 2021 / early 2022, the taper process could be concluded in six months. This could be followed by another six months (approximately) of waiting before the rate hike cycle begins in earnest.

With the markets positioned a tad on the dovish side, this shift in Fed communication drove yields in the 5Y and 10Y segments sharply higher. 10Y yields are now just shy of 1.60%. There were some minor operation tweaks done at the short-end of policy rates, with interest on excess reserves (IOER) and the overnight reverse repo agreements rate were increased by 5 bps each to 0.15% and 0.05% respectively.

We are sticking to our view that USD rates will be biased higher and see 10Y yields heading towards the top of the 1.5-2.0% pre-pandemic range. It is a welcome surprise that the Fed is revisiting its dual mandate, putting some emphasis on inflation again. On a side note, the Fed raised the RRP rate and IOER by 5bps, suggesting that they are also concerned about excess liquidity, which actually adds to reasons for taper. With the Fed giving a clear signal that taper is upcoming, we suspect that other central banks will be more comfortable taking steps to withdraw extraordinary stimulus. Summer may not be that calm as economic data (payrolls and inflation) matter once again.

Strategy-wise, we reckon that pay on dips would probably be best way to handle the markets. As a reference, we think 10Y yields below 1.5% look fundamentally detached. For the curve, it may be tougher to get a clear handle. Curve flattening over the past few weeks was largely driven by a reduction in term premium (complacency on Fed taper), a slight easing of inflation worries (as measured by breakevens) and the frontloading of rate hike expectations (overnight). We do think that the curve (2Y/10Y, 5Y/30Y) would flatten over the next few quarters as we draw closer to Fed liftoff in late 2022/2023. However, the market may not quite have digested the possibility that taper may take place much faster than the previous cycle (possibly just six months). It may make sense to await better levels before putting on flattening trades.

To read the full report, click here to Download the PDF.

Eugene Leow

Rates Strategist - G3 & Asia

Subscribe here to receive our economics & macro strategy materials.
To unsubscribe, please click here.

The information herein is published by DBS Bank Ltd and/or DBS Bank (Hong Kong) Limited (each and/or collectively, the “Company”). This report is intended for “Accredited Investors” and “Institutional Investors” (defined under the Financial Advisers Act and Securities and Futures Act of Singapore, and their subsidiary legislation), as well as “Professional Investors” (defined under the Securities and Futures Ordinance of Hong Kong) only. It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. This research is prepared for general circulation.  Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.  The information herein is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of or located in any locality, state, country, or other jurisdiction (including but not limited to citizens or residents of the United States of America) where such distribution, publication, availability or use would be contrary to law or regulation.  The information is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction (including but not limited to the United States of America) where such an offer or solicitation would be contrary to law or regulation.

This report is distributed in Singapore by DBS Bank Ltd (Company Regn. No. 196800306E) which is Exempt Financial Advisers as defined in the Financial Advisers Act and regulated by the Monetary Authority of Singapore. DBS Bank Ltd may distribute reports produced by its respective foreign entities, affiliates or other foreign research houses pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Singapore recipients should contact DBS Bank Ltd at 65-6878-8888 for matters arising from, or in connection with the report.

DBS Bank Ltd., 12 Marina Boulevard, Marina Bay Financial Centre Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E. 

DBS Bank Ltd., Hong Kong Branch, a company incorporated in Singapore with limited liability.  18th Floor, The Center, 99 Queen’s Road Central, Central, Hong Kong SAR.

DBS Bank (Hong Kong) Limited, a company incorporated in Hong Kong with limited liability.  13th Floor One Island East, 18 Westlands Road, Quarry Bay, Hong Kong SAR

Virtual currencies are highly speculative digital "virtual commodities", and are not currencies. It is not a financial product approved by the Taiwan Financial Supervisory Commission, and the safeguards of the existing investor protection regime does not apply.  The prices of virtual currencies may fluctuate greatly, and the investment risk is high. Before engaging in such transactions, the investor should carefully assess the risks, and seek its own independent advice.