10-2 Treasury Yield Curve Almost Compels Fed Balance Sheet Runoff

10-2 Treasury Yield Spread

The 10-2 yield curve will be a concern for the Fed. Since April 2021 it has been flattening considerably (blue square area). The Fed has indicated three rate hikes for 2022, and the market sees a distinct possibility for a fourth. However, the Fed (and central banks in general) tend to operate on the short-term side of the yield curve. This means that, in isolation, these rate hikes are likely to flatten the yield curve even further.

Source:. www.tradingview.com

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US 10 Yr. Treasury

The US 10 Yr. Treasury yield has completed its inverted head and shoulders pattern. This is a basing pattern (in this case for yields) and suggests higher yields ahead. In this regard, the measured move gives a target of around 3% (red dash horizontal). We do note that technical targets are academic; they may or may not be hit. Nevertheless, the flattening of the yield curve denotes that the rate of change in the 10 Yr. yield is incongruent with the rate of change in the US 2 Yr. yield given where we are in the economic cycle (7% inflation and almost at full employment).

Source: www.tradingview.com

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The Fed Balance Sheet

The chart below shows that the Fed's assets have more than doubled from near $4tn in Feb 2020 to $8.8tn currently. This, as a result of the Fed's quantitative easing (QE) policy to stabilise the economy, during the pandemic period. QE allowed the central banks to control longer-term rates on the yield curve by purchasing longer-term fixed-income assets and capitalising them on the balance sheet. Longer-term yields are market-driven, as opposed to being central bank-driven when QE is absent. However, a large part of the lack of sensitivity in the US 10Yr.'s rate of change is likely due to the unconventional monetary policy implemented by the Fed. In response to the 7% inflation reading, and before the Senate Banking Committee yesterday, Fed Chair Powell stated, "what that's...telling us is that the economy no longer needs or wants the very highly accommodative policies that we've had in place to deal with the pandemic and its aftermath." This suggests that to normalise longer-term rate-sensitivity, an unwinding of the Fed's balance sheet is appropriate.

Source: https://fred.stlouisfed.org/

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Featured Image by Gerd Altmann from Pixabay

Other References:

Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.

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