Two months ago, before the Fed's rate hike was largely perceived as a market-spooking policy mistake, we laid out Deutsche Bank's three stage scenario on how to trade "The Fed's Upcoming "Policy Error", one which could be summarized as follows: the 10Y starts off strong, weakens into the summer to 2.50% on tantrum fears, then proceeds to surge higher as the Fed acknowledges its error, and hits a yield of 2.00% at the end of the year.
Over the weekend, DB's credit team revised its forecast for what it believes the 10Y will do: what Dominic Konstam et al. found was that with both equities and TSYs (which recently dipped below 2.0% well ahead of scheduled) reacting far more aggressively to the tightening in financial conditions, it was prudent to shift the entire forecasted curve by 25 bps lower as follows.
DB's full thinking is laid out below:
In our 2016 outlook piece we argued that yields were likely to peak in the second quarter in what we were describing as a “mini-tantrum”. We argued this was likely around a potential March rate hike, when the Fed’s strength of resolve to push rates higher was likely to be somewhat more opaque. Importantly, this projection was largely predicated upon our more optimistic house view of Chinese growth prospects and the DB view that China would continue to manage its currency lower without an abrupt devaluation. This said, we accounted for uncertainty around these views with a confidence interval around our central expectations.
Our fair value model which incorporates the Fed, inflation survey and structural deficit variables suggests that 10yr yields are currently 60 bps rich to fair value. The modeled yield of 2.57% is roughly where we originally pinned our Q1 2016 Outlook forecast.
Fiscal easing is consistent with a drift higher in rates. In our model, each percentage increase in deficit spending relative to GDP is worth (positive) 11 bps in yields. The CBO projects the federal deficit to climb to 2.1 percent of GDP in 2016, up from 1.9 percent last year. The deficit is expected to widen over the next several years, reaching 3.7 percent of GDP in 2022.
In this way, to the extent that the domestic US data followed the Fed and DB house forecasts, it would have allowed the Fed to carry on raising rates in March and potentially beyond. The “mini-tantrum” could in that light simply have been the catalyst for pushing yields back toward fair value in a world where tighter financial conditions were fleeting and growth remained as healthy as forecast. Increases in the household savings rate that “accommodate” or offset the decline in the public sector’s savings-investment balance, however, reduce growth and scope for higher yields.
The most recent data and the financial volatility emanating from China increase the uncertainty around our baseline house forecasts. From the standpoint of the “contours” of rates this year, however, we still think a move higher, then lower makes sense, although with a couple of caveats.
First, given the data and ongoing risk market volatility, we see a moderate shift lower in the path of yields. This leaves our base case looking more like the bottom of the confidence interval from the 2016 Outlook.
Second, the catalyst for a Q2 peak in yields is on the margin more likely to be a Fed relent rather than Fed scare and mini-tantrum.
This is consistent with our contention that higher rates are feasible given a relent than given Fed tightening because the relent allows more time for growth to shift toward productivity-enhancing investment rather than late cycle growth via labor hoarding. Before “normalization” is possible, a consumer demand driven increase in productivity is probably necessary. The problem, however, is that higher savings are absorbing the oil tax rebate, and risk market volatility is likely to push the savings rate up further, if anything. It is a persistent increase in the savings rate that is likely to trigger Fed relent, in our view.
As we have consistently argued, the Fed’s relent would also significantly reduce pressure on the dollar to appreciate. This might reduce risk of a disorderly resolution to China’s currency adjustment, and anyway would ease downward pressure on commodities and reduce the risk of pass-through from headline to core inflation.
The market implication, then, is that before investors sell 10s, they need the Fed to pause. The Fed could either skip March and signal a pause, or hike at the March meeting and signal a longer pause. The latter case is maybe more palatable and effective since it should permit a longer pause. So the curve flattens into March 2s10s with risk off market dynamics and an increasing probability of relent, followed by bear steepening after a Fed pause. Rates could then stabilize or decline, depending on whether recession is avoided or at least postponed.
It wasn't just DB: over the weekend JPM also cut its 2Y and 10Y yield forecasts by 30bp to 1.45% and 2.45%. The longer the 10Y hangs around 2%, the more strategists are expected to cut their year end forecasts, including Goldman who famously admitted its 2015 year end 3.00% prediction was wrong, only to forecast the 10Y closing 2016 at... 3.00%