USD Rates: Regime shift from the post-GFC environment?

Shifting to an era of higher rates.
Group Research, Eugene Leow23 Sep 2022
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    There’s still no respite in the selloff in DM government bonds. Overnight, longer-tenor bonds bore the brunt of the hit, rotating from the shorter tenors. 10Y US yields have now topped 3.70% and appear on track to touch 4% (levels last seen in 2010. The brutal selloff in government bonds is echoed across the DM as the market comes to terms with persistently high inflation and aggressive central banks. The BOJ is the exception within the G10 and has even provided dovish guidance for the next few years. The persistent rise in DM yields might mark a regime shift. While it may be too early to tell for certain, we can monitor selected indicators to see if this is the case and that bond markets are finally shaking off the “bubble” in the post-GFC environment where asset purchases largely depressed yields.

    One key area to monitor would be implied real yields. In the post-GFC era, real yields were considered tight at around 1% (and rarely go above). When Fed Chair Powell tried to push for more hikes in late 2018, it backfired, resulting in cuts in 2019. Real yields across the curve are now firmly above 1%. In the pre-GFC environment, it is possible for real yields to be sustained closer to 2% for an extended period. Note that 5Y5Y implied real rates (using SOFR OIS), which should theoretically strip out any of the short term inflation and policy noises, are now close to 0.7%. A move towards 1% is plausible.

    The second area to consider is financial conditions. The market might be getting accustomed to higher rates. Stresses as measured by financial conditions indices are still not as bad as that seen in 2Q. This provides leeway for the Fed to sound hawkish in the face of strong data. In short, financial conditions, while moderately stress, are still not yet at levels to impede yield increases. 

    Lastly, US data has proven to be surprisingly resilient despite market volatility. By some measures (such as household debt), the US is in a much firmer position now compared to any other time post-GFC. If the US looks about as strong as the period around 2006, then perhaps interest rates can rise closer to those levels. Overnight, jobless claims stayed low, pointing to a still resilient labour market. Note that despite signs of firing, job opportunities are still plentiful. There might also be a need to differentiate between the adjustments to the different industries and there may yet be net gains in NFP even if the tech / real estate sector comes under stress.

    The upshot is that regime shift will take time to confirm. Meanwhile, it does look like a shift is taking place based on the indicators we are monitoring. However, this points to a volatile rates space for a while more as market participants fret about hardlanding worries if the face of rapidly rising interest rates.

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
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