US Rates Market Ponders Fed Taper and Rising Energy Prices

Following the FOMC’s Sep 22 meeting, Treasury yields at all points on the curve moved higher. The 2y U.S. Treasury yield moved from 24bps to 43bps, the 5y UST widened from 90bps to 1.18%, and the 10y increased from 1.30% to 1.62%

This was a reasonably significant move given that many of the secular forces at work keeping yields lower over the summer – foreign buying due to relative rate differentials, concern over a weak China economic outlook US pension fund buying, etc – have not changed. Furthermore, the expected large US infrastructure and social spending stimulus plans have not yet materialised – and may be greatly reduced in size if they do, potentially leading to less UST debt issuance in the future than previously thought.

It is possible that the impetus for the strong shift higher in rates was not just the expectation of a taper announcement, but – spurred by global energy price hikes – a rethinking of how climate change and associated decarbonization efforts may require much higher level of investment than previously anticipated, most likely to be funded primarily by government stimulus. This may increase inflation expectations.

Citi analysts think that the Fed may formally announce its taper at its next meeting on Nov 2, with the taper to commence either in November or December at a pace of US$15bn per month, and to conclude by early summer of 2022. While still accommodative, the Fed may be incrementally less so each month, and Citi analysts think that may reduce the buying pressure on the long-end of the curve to allow it to catch-up with current inflation pricing (and perhaps impact inflation pricing lower as well). Citi analysts still think the 10y UST may finish the year in its current 1.50-2% range, but the yield may drift slightly higher in 2022 as taper concludes and a rate-hiking cycle commences towards the end of 2022.