News Story - the BondBeat

November 2017 U.S. Rates Outlook BI Interest Rates, North America Dashboard Ira F Jersey Team: Strategy BI Rates Strategist

1. As Yield Curve Flattens, Fed Faces Policy Conundrum (Bloomberg Intelligence) -- By the end of 2018 two Federal Reserve hikes are priced in, yet the dot plot shows four. The Treasury Department will announce more issuance amid a relatively healthy economic backdrop. Yields don't necessarily need to go higher, but curves could get flatter, posing challenges to the central bank. (11/08/17)

Table of Contents Topics Nov. 2017 Monthly Update NEW Nov. 2017 Relative Value NEW Nov. 2017 Forecast Updates NEW

Topics Nov. 2017 Monthly Update

Policy Makers' Dilemma: Remove Accommodation Without Flattening The Treasury curve is the flattest in a decade, yet still has room to bear flatten further, even with 10-year yields range-bound. Flat curves tend to precede economic slowdowns. Tightening faster than currently priced would lead to further flattening - and sound alarms of an imminent policy mistake. (11/08/17)

2. November Capital Markets Monthly Webinar Invite The November 2017 Bloomberg Intelligence Capital Markets monthly webinar will feature BI Strategy's 2018 Outlook for Equities, U.S. Rates and Commodities, with a focus on how monetary and fiscal policy changes are affecting investment opportunities across asset classes. The BI monthly webinar features Equity Strategist Gina Martin Adams, U.S. Rates Strategist Ira Jersey and other members of the Bloomberg Intelligence Strategy team. They will provide thematic views and updated thoughts on various markets. (11/08/17) Invite to BI Capital Markets Monthly Webinar

3. Real Yields Continuing in the Range This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiariesin all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global marketingand operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice,and nothing herein shall constitute an offer of financial instruments by BFLP, BLP or their affiliates.

Rate market volatility, both implied and realized, has once again plummeted to multiyear lows as 10-year yields bounced off their highest level since March. The move to and reversal from 2.45% on the 10-year yield was from real yields, which have been in a 25-70-bp range since December 2016. The break of the September to late October uptrend in real yields points toward a test of the 25-bp level. Such a move without an uptick in inflation expectations points to another test of 2.1% in 10-year yields. As new Federal Reserve appointees take center stage in policy analysis, the front end of the yield curve takes the limelight as the market continues to price for only two rate increases by late 2018. The pricing for additional hikes would lead additional curve flattening. (11/08/17) Technicals of Real Yields Point to 20-Bp Rally

4. Treasury Curve Might Be Harbinger of Doom The Treasury curve should continue to flatten as the Federal Reserve proceeds with rate hikes, particularly if it's at a pace faster than is currently priced in. Though the curve is the flattest in a decade, hiking cycles typically lead to curves even flatter than this. The question of whether flat curves are a cause or an effect of slowdowns in the economy remains dicey. It does appear that curve flattening precedes reductions in industrial production (IP) by about a year. Statistically, the two-year/10-year Treasury curve Granger causes the trend adjusted level of IP at a 12-month lag. However, the reverse isn't true as IP doesn't Granger cause curve moves. The trend-adjusted IP series is relatively stationary. A Granger causality test is a gauge of cause and effect. (11/08/17) Treasury Curve vs. Trend Adjusted IP Index

5. More Debt Means Lower Yields? Although counterintuitive, large upticks in debt issuance historically have coincided with Treasury market rallies and lower yields. The primary reason is slowing economic growth, falling inflation and lower policy rates. This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiariesin all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global marketingand operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice,and nothing herein shall constitute an offer of financial instruments by BFLP, BLP or their affiliates.

Therefore, it's far from a given that yields will rise on additional debt issued to the public over the next several years stemming from potential tax cuts, Federal Reserve balance-sheet runoff, and demographic-related budget deficits as social security and Medicare payments increase. However, unless the economy weakens, the increase in public issuance may play out differently. An across-theboard increase in supply could see yields rise across the curve. This is why the Treasury Department will likely be cautious in increasing auction sizes and start with short-term securities. (11/08/17) Yields Have Tended to Fall With More Debt

Nov. 2017 Relative Value

Rates Market Lacks Volatility, Not Relative Value Opportunities Even with implied rate volatility making new multiyear lows, there are relative value opportunities across a variety of rates instruments. (11/08/17)

6. Volatility Is Again at Multiyear Lows Swaption implied volatility has fallen to new mutliyear lows after the brief mid-October spike. However, longerterm expiries are lagging shorter-term ones, pushing the three-month/10-year vs. one-year/10-year spread to the highest level since 2014. The move in gamma comes amid the market pricing for a December Federal Reserve interest-rate hike, while the path of moves in 2018 is less certain. One-year/10-year payer skew remains higher than in early October but well-below the levels of December 2016. One would expect a strong jump in volatility by those hedging the possibility of higher rates if the market believed that a creditable tax bill was coming in the near term, or if the Fed were going to be more aggressive than is currently priced. (11/08/17)

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiariesin all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global marketingand operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice,and nothing herein shall constitute an offer of financial instruments by BFLP, BLP or their affiliates.

Calendar Spread Widening as Gamma Falls Further

7. 10-Year Cheapening on Butterfly But Not Curve Although outright the 10-year Treasury has remains in the middle of it's broad 2.1-2.45% yield range, the 10-year maturity has been underperforming on the curve. It has underperformed by 6 bps on the five-year/10-year/30year (called 5s/10s/30s) butterfly since early September, but now sits right on its two-month trend line. A break of this trend suggests 10s can outperform on the fly. Should the trend continue, it will reach an important technical resistance in mid-December. In the year to September, the two-year/10-year curve and the 5s/10s/30s butterfly were highly correlated; however the correlation has broken down since late September as 2s/10s flattened with 10s selling off on the fly. (11/08/17)

10-year Treasury Trending Underperforming on Curve

8. Real Yield Curves Have Flattened Recent moves in the nominal yield curve have come as the result of moves in real yield. Unlike the spike in inflation expectations at the end of 2016, the curve flattening has come primarily from real yield curve flattening -both bull and bear. Over the last six months, short-end real yields have sold off, with two-year real yield more than 10 bps higher. TIPS yields beyond five years have rallied, with seven-year real yields lower by about 8 bps. (11/08/17)


Real Yield Flattening Has Pivoted at the Five-Year

9. GOVY Relative Value Screen Contributing Analysts Tony Park (Strategy)

Treasury bonds maturing in 2023 are about 1 bp tighter than the Bloomberg fitted Treasury curve, while most notes in the five-year sector are slightly wider than the model. The {GOVY } function highlights bonds relative to a chosen theoretical yield curve. The function shows bonds that have moved significantly against the model based on z-score and illustrates the spread of the individual issue to the curve. Theoretically, the most attractive bonds are wide to the model with a z-score above 1; the least attractive have a negative spread and z-score below minus 1. The fitted yields implied by the Bloomberg U.S. Government spline curve (YCRV0001 Index) show hypothetical yield at each point on the curve. (11/08/17) 2023 Bonds Rich to Bloomberg Model Curve

Nov. 2017 Forecast Updates

Bear-Flattening Treasury Curve Is Near-Term Scenario Rates markets remain skeptical that the Federal Reserve will raise rates more than twice before the end of 2018. Pricing for another hike should mean a bear flattening of the yield curve. BI's Treasury yield projections are below consensus, but if consensus economic forecasts are realized, the 10-year yield could reach 3%. (11/08/17)

10. November 2017 Treasury Yield Forecast: More Bear Flattening Bloomberg Intelligence expects longer-maturity yields to move only modestly higher, but is revising yield forecasts higher for the short end of the curve. The market is pricing only slightly more than two hikes by the end of 2018 (in December 2017 and next summer). Bloomberg Economics expects an increase in December and two hikes in This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and distributed locally by Bloomberg Finance LP ("BFLP") and its subsidiariesin all jurisdictions other than Argentina, Bermuda, China, India, Japan and Korea (the ("BFLP Countries"). BFLP is a wholly-owned subsidiary of Bloomberg LP ("BLP"). BLP provides BFLP with all the global marketingand operational support and service for the Services and distributes the Services either directly or through a non-BFLP subsidiary in the BLP Countries. BFLP, BLP and their affiliates do not provide investment advice,and nothing herein shall constitute an offer of financial instruments by BFLP, BLP or their affiliates.

2018. There's a high probability that the market will price this in at some point, which should spur curves to bear flatten further amid a front-end selloff. BI yield forecasts remain below consensus estimates across the curve, but consensus has fallen. Consensus for the 10-year Treasury yield for year-end 2018 is 2.82%, down from 2.93% a month ago. This compares with the BI forecast of 2.65%, which is unchanged on the month. (11/08/17) Bloomberg Intelligence Treasury Yield Forecasts

11. November 2017 Treasury Issuance Forecast Update Coupon issuance should begin to slowly rise starting in February, with the Treasury Department saying as much in its quarterly refunding statement. BI's forecast had been for a slow increase to front-end coupons starting this month. Given the statement, our forecast is now for a faster increase of two- and three-year coupon issuance starting in February, and more modest increases in other maturities beginning at that time. Net T-bill issuance should run in normal seasonal patterns. The assumptions used in these forecasts are that the Treasury keeps a $100-$300 billion cash balance (mostly on the higher end), a modest increase in student loans and an additional $170 billion in deficits allowed in the budget approved by Congress. (11/08/17) BI Treasury Issuance Forecasts, US$ Bln

12. Model Points to Near 3% 10-Year Yield, Given Economic Consensus As of the end of October, the 10-year Treasury yield was within 1 bp of the Bloomberg Intelligence fair value yield model, given 4Q consensus forecasts. Fair value for yields increases to 2.93% at the end of 2018 if consensus economic forecasts are fulfilled. This would be meaningfully higher than implied forward rates of 2.43%. The market appears skeptical that consensus Fed hikes (three) or economic data (2.4% GDP and 2.1% CPI) will be realized. The fair value model uses monthly estimates of GDP, actual headline CPI, the policy rate and the Fed's balance sheet as a percentage of the Treasury market as inputs. The model has an r-squared of 0.85 but a relatively high standard error of about 100 bps. (11/08/17)


Modeled 10-Year Yields, With Consensus Projection

To contact the analyst for this research: Ira F Jersey at [email protected]
