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Bond Traders' Roadmap After Midterms: Fed Hikes and Supply Risks

Bond Traders' Roadmap After Midterms: Fed Hikes and Supply Risks

(Bloomberg) -- The relative tranquility in Treasuries following U.S. midterm elections may not last as bond traders contemplate the potential for legislative wrangles over spending and borrowing, and turn their attention to risks such swelling supply and Federal Reserve policy tightening. While the emergence of a split Congress was largely in line with market expectations, it remains unclear what that will ultimately mean for America’s economy, fiscal policy and the world’s biggest bond market.

Key Insights

  • Fed Hikes Ahead: Given solid U.S. economic data and inflation finally bubbling upward, the Federal Reserve -- which is set to announce a policy decision Thursday -- is still primed to continue raising rates gradually. Fed funds futures are priced for another move in December, followed by two more in 2019, although that’s still less than the three hikes that Fed officials have signaled as likely for next year.
  • Supply Concerns: Investors are already having to digest record-sized Treasury auctions, and there could be more borrowing to come. A House led by the Democrats raises the specter of possible infrastructure spending, and President Donald Trump said at a news conference Wednesday that dealmaking may be easier with a Democratic House. On top of that, recent government bond sales have already shown signs of weakening demand.
  • Fiscal Deadlines: Money-market traders may face bouts of volatility as fiscal deadlines loom even larger now, including Dec. 7, when spending authority under the current continuing resolution comes to an end. After that, the biggest risk next year is for a protracted battle over the debt ceiling. Trump said at his news conference that a shutdown strategy may not be needed.
  • The International Dimension: Trump’s more limited room for maneuvering domestically may also spur the commander-in-chief to focus on international affairs by intensifying the trade war. That could spur further swings in the Chinese yuan and emerging markets, which could in turn affect U.S. assets.

Market Action

  • The yield on the benchmark 10-year note fell about 3 basis points to 3.20 percent Wednesday, and its gap over the rate on two-year securities has narrowed to about 26 basis points. The spread between 5-year and 30-year yields also tightened, although the curve resteepened slightly following a weak long-bond auction Wednesday.
  • The Bloomberg dollar index shed about 0.2 percent, with the greenback falling against most of its Group-of-10 peers.
  • Volatility as gauged by options on 10-year interest rates swaps fell around 3 basis points.

Looking Ahead

  • Democratic control of the House should lead to lower long-end rates and a “modestly flatter yield curve,” Bank of America strategists said in a note. Downside risks to the bank’s year-end forecast for the 10-year yield at 3.25 percent stem from potential gridlock in Washington, which could limit policy action to “the bare minimum of raising the debt ceiling and keeping the government funded, which should result in modest budget increases.”
  • “The midterms are unlikely to have a significant bearing on the economy,” Capital Economics U.S. economist Andrew Hunter wrote in a note. “But they probably raise the risk that political uncertainty once again becomes the dominant theme over the next couple of years.”
  • “The results of the election shouldn’t change the immediate path of the economy or monetary policy,” independent strategist Marty Mitchell said in a note, citing the Trump administration’s already implemented fiscal initiatives. “For these reasons, the Fed will continue to lift the fed funds rate and the U.S. yield curve should maintain an upward bias going forward from here.”
  • NatWest Markets strategist John Briggs suggests fading the long-end buying in Treasuries, because once the dust settles, market movements will be “more muted” and quickly refocus on the underlying fundamentals and upcoming events. Briggs also said political gridlock may give way to increased spending. “When it comes to budgeting, the only way to agree on a budget may be to give candy to everyone, and spend more rather than less,” he said.
  • “Trade uncertainties, investigations and impeachment threats are downside risks,” Dana Peterson, an economist at Citigroup, wrote in a note. “The persistence of U.S. trade disputes with other economies, including China and the EU poses downside risk to global (and ultimately U.S. growth) via trade, confidence and inflation channels.”
  • Wells Fargo strategists including Mike Schumacher still expect the Treasury curve to bear steepen by the end of 2018 and through next year, given midterm election impact on the U.S. bond market typically fades within a week and supply remains heavy. Plus, there’s “little link between Congressional control and spending,” they wrote in a note to clients.
  • Going forward, the removal of uncertainty and realization of the expected outcome should be supportive for risk assets, the yield curve returning to a more normal flattening pattern, and a modestly weaker broad dollar, Goldman Sachs analysts wrote in a note.
  • “With election results in hand and largely in line with expectations, the bond market quickly looks ahead to Thursday’s FOMC announcement,” said Colin Lundgren, global head of fixed income at Columbia Threadneedle Investments. “ No rate hike expected this month, but investors will be looking for language in the statement that highlight the Fed’s concern for changing financial conditions, and potential impact on future policy decisions.”

--With assistance from Sydney Maki, Katherine Greifeld and Molly Smith.

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net;Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum

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