The U.S. Treasury market kicked off the new year of trading in volatile fashion as the 10-year Treasury sold off nearly 13 basis points on January 3, a daily yield jump that occurred only twice in 2021, leaving investors wondering about potential catalysts. We attribute the move to a combination of factors that were building up, but not traded, during the illiquid last two weeks of 2021 such as a weak seven-year Treasury auction and solid economic numbers. Additionally, a large slate of corporate issuance combined with positive risk sentiment—equities up, curve steeper, breakeven inflation higher—was enough of an impulse to push the 10-year back above 1.6%, a level not observed since the post-Thanksgiving rally on initial Omicron fears. Front-end interest rates also reflected this sentiment via a more hawkish Fed stance with Eurodollar futures selling off especially in the 2023 – 2024 part of the curve.
Looking forward to the rest of the quarter, we expect more days of volatility for the U.S. rates market. For one, each day as we get closer to the Fed’s exit from the zero lower bound—the market is currently pricing a full hike by May 2022—the incoming economic data, which we expect to be strong for both jobs and inflation, will become more signal and less noise for the Fed’ reaction function. Second, the gap between the market’s expectations of the terminal rate for this upcoming hiking cycle versus the Fed’s should converge as we get closer to, and ultimately begin, rate normalization. This will impart more upward pressure on both nominal and real rates as the regime of extraordinary monetary accommodation begins to unwind. Near term, a reasonable target for this move is 1.75% on the 10-year rate.
Typically, this backdrop drives the curve flatter; however, despite a highly entrenched flattening move in the second half of 2021, we expect the curve to be more balanced in our envisioned scenario. Given the current flatness of the curve both historically and relative to our inferred place in the monetary cycle, we anticipate the magnitude of flattening and steepening moves to be roughly equal over the first quarter of 2022, leading to more two-way price action.