Latest In Markets - Front-End Selloffs
(This post kicks off the “Latest in Markets” series of the Invariant Investments blog, where we will comment on what we believe to be the most interesting stories in global markets across asset classes and discuss potential implications.)
Over the past few months, the “front-end” of the U.S. treasury yield curve has been selling off (note: selling off is the same thing as rates rising) and has even accelerated in recent weeks. This post will summarize what has transpired in short-term interest rate markets. But before we can dive into why front-end rates are rising and how it may impact portfolios, we must first define “yield curve” and identify the primary drivers of the different points on the curve.
What is the Yield Curve?
The yield curve charts a country’s interest rates across all maturities—from front end rates, which are set by the central bank, to long-term rates traded in the market. The yield curve is important because many market participants believe that the yield curve is a leading indicator for economic conditions and can be useful for forecasting and risk management. While the exact definitions vary, economists often separate the yield curve into three separate categories: the “front-end”, the “belly”, and the “long end.”’
Front-End: The “front-end” typically includes to overnight rates, which are explicitly set by the central bank, up to the 3-year tenor, which are predominantly driven by expectations of the path of overnight rates.
Belly: The “belly” typically includes to treasury securities longer than 3 years to maturity and shorter than 10 years and is driven primarily by a combination of expected path of overnight rates and inflation expectations.
Long-End: The “long-end” typically includes to treasury securities with 10 years or greater to maturity and driven primarily by inflation expectations.
Current State of the U.S. Treasury Yield Curve
Below, you will see the U.S. Treasury Yield Curve at four different points in time this year: 1/15/2021, 4/15/2021, 7/15/2021, and 10/15/2021.
(Source: http://www.treasury.gov)
Between January 2021 and mid-October 2021, the three-year U.S. treasury rate dramatically increased from .2% to .7%. The rapid rise in short term rates indicates that market participants increasingly believe that the Federal Reserve will raise overnight rates in response to inflationary pressures much sooner than they previously anticipated.
CME FedWatch Tool
The diagram below comes from a great resource from the Chicago Mercantile Exchange called the “FedWatch Tool.” The FedWatch tool calculates market-implied probabilities of rate hikes/cuts from the Fed Funds futures markets, which allows market participants to trade on where they believe policy rates will be at expiration.
When we look at the September 2022 expiration, we see that the market-implied probabilities for higher overnight rates have risen significantly over the past month, confirming what we are seeing in the front end of the treasury curve described above.
To see market pricing and learn more about Fed Fund futures, check out the CME Group website.
(Chart as of 10/18/2021 - https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html#)
International
The increasingly hawkish pricing in the front end of the yield curve is not limited to the United States. Many other countries’ fixed income markets have priced in a hike cycle sooner than the U.S. See examples below:
(https://www.marketwatch.com/investing/bond/tmbmbca-01y?countrycode=bx)
(https://www.marketwatch.com/investing/bond/tmbmkgb-01y?countrycode=bx)
(https://www.marketwatch.com/investing/bond/tmbmknz-02y?countrycode=bx)
There are many more examples as expectations for central bank tightening are a global phenomenon.
The Bottom Line
Markets are increasingly pricing in greater probabilities that central banks will hike interest rates in reaction to rising prices. In fact, many countries are already in full-fledged hike cycles. Depending upon how tactical you are with your portfolio and how you assess of the likelihood of the hike cycle beginning in mid-2022, these developments may call for adjustments to your asset allocation, duration exposure (overall portfolio sensitivity to movements in interest rates), credit risk exposure (overall portfolio sensitivity to changes in credit spreads), and equity allocation sector over/underweights.