Fixed income strategy
The author is an analyst for Shinhan Securities. He can be reached at jk.ahn@shinhan.com -- Ed.
US government and Fed seek to bring down inflation without a recession
The US Fed is seeking to stabilize inflation at lower levels without a recession in hopes of avoiding a repeat of the 1970s. It has raised rates by about 525bp since 2022, but the US economy has remained stable in terms of employment, consumption, housing, and finance. Consumption, which accounts for 70% of US GDP, is likely to slow down going forward. However, the country’s growing investments, led by the construction sector, have helped to dispel recession worries. The US may consider itself lucky, but is holding out well against the impact of rate hikes. Nevertheless, recession signals are flashing in the bond market as the yield curve inversion deepens. Fears about recession could become a self-fulfilling prophecy. Such fears could be mitigated by reversing the inverted yield curve.
Fed’s future policy mix: Rate changes in line with economic trends and QT
The Fed is expected to focus on reversing the yield curve inversion. The extent of the inversion will need to be reduced, even if it cannot be fully reversed. First of all, the Fed is forecast to keep reducing its balance sheet. The adequate amount of reserves is considered to be 10-11% of GDP. At the current pace of quantitative tightening (QT), it has to work on shrinking its asset holdings for about three years.
Meanwhile, the Fed’s future rate changes should be made in line with economic trends. The economic downturn caused by slowing consumption and high interest burden on the federal government point to rate cuts down the road. We expect the Fed to adjust policy rates while closely monitoring economic developments, and continue on its tightening path. Fed governor Christopher Waller has stated since January that the central bank can reduce its assets along with rate cuts. Fed Chair Jerome Powell also mentioned in July that the balance sheet runoff can continue even when rate cuts begin, drawing a line between interest rate adjustments and asset purchases. We believe the balance sheet runoff will continue during periods of rate cuts.
Implications for bond market: Bear steepening followed by bull steepening
The yield curve is projected to bear-steepen if the Fed moves to adjust rates and reduce its balance sheet at the same time. Bull-steepening expectations should grow once long-term bonds are issued as planned in 2H23. From now on, we need to look out for a possible end to the Fed’s rate hike cycle and auction results for Treasury notes. Bear steepening will likely win out until the September FOMC meeting, and then give way to bull steepening. The domestic bond market will be affected by the bear steepening of the US yield curve, but concerns over new KTB issues remain limited. Korea’s budget for 2024, set to be announced at the end of August, should increase only slightly by 3% levels YoY. Long-term KTB yields are forecast to peak before short-term yields upon the confirmation of a reduction in new KTB issuance.