October 23, 2017 / 8:46 PM / 2 years ago

Bets on hawkish Fed flattens U.S. yield curve

NEW YORK (Reuters) - The U.S. bond market is signaling that traders are setting up for more aggressive monetary policy tightening if a new leader takes over the Federal Reserve.

Federal Reserve Chairman Janet Yellen speaks during a news conference after a two-day Federal Open Markets Committee (FOMC) policy meeting, in Washington, U.S., September 20, 2017. REUTERS/Joshua Roberts

Speculators have amassed record net positions betting that shorter-dated U.S. Treasury yields would rise faster than longer-dated yields if U.S. President Donald Trump names someone new to replace Janet Yellen as Fed chair.

On Monday, the U.S. yield curve, as depicted by the gap between two-year and 10-year Treasury yields, stood at 80 basis points. The curve is slightly steeper than the 78 basis points reached earlier this month, its flattest in over 13 months.

All-time net shorts in two-year and five-year Treasury futures have also been stoked by expectations of tax cuts, which are forecast to bolster economic growth, allowing the Fed to hike rates further.

(Graphic - Speculators bet against 2-year Treasuries: reut.rs/2ldC40b)

Trump is expected to announce his nominee for Fed chair before he leaves for his Asia trip beginnng on Nov. 3. Trump has said he is considering Fed Governor Jerome Powell, Stanford University economist John Taylor, as well as Yellen herself, whose term expires in early February.

Trump has also interviewed former Fed Governor Kevin Warsh and his economic adviser Gary Cohn for the top Fed post.

Taylor has the most hawkish reputation among the five candidates due to his approach for wider use of a rule for setting interest rates. Based on his view, the Fed’s interest rate target should be higher than the current 1.00-1.25 percent range.

On the other hand, Powell has sided with Yellen’s stance to gradually raise rates from the emergency low levels adopted during the 2007-2009 global financial crisis.

Unlike Yellen, Powell, a Republican whom Treasury Secretary Steve Mnuchin is said to support, has expressed his openness to scaling back the post-crisis set of tighter bank regulations implemented during the Obama administration.

While Trump has expressed his preference for low interest rates, Bloomberg reported a week ago that Taylor impressed Trump in his interviews, raising Taylor’s perceived chances.

“The market move accelerated last week with the story between Trump and Taylor, who had seemed out of the running,” said Tom Simons, money market strategist at Jefferies & Co in New York.

While some traders’ expectations that Taylor’s chances as the next Fed chief have grown, many analysts and prediction markets signaled Powell is the front runner.

“What has been priced in is continuity and perhaps a hawkish surprise,” said Alan Ruskin, global co-head of currency strategy with Deutsche Bank in New York.

To be sure, if Trump ends up picking Yellen, the yield curve would steepen, led by a drop in short-dated yields as the Fed would stick with a cautious stance regarding raising rates, analysts said.

(Graphic - Speculators bet against 5-year Treasuries: reut.rs/2y0s4NE)

Still, speculators have ratcheted up bets that the Fed will swing from Yellen’s dovish bent in a not too distant future.

Speculative net shorts in two-year Treasury notes rose for four straight weeks to a record high of 312,453 contracts on Oct. 17, while speculators raised their net shorts in five-year Treasury futures to 445,579, the most on record, according to Commodity Futures Trading Commission data released on Friday.

On Monday, the two-year Treasury yield US2YT=RR reached 1.589 percent, the highest level since November 2008, while the five-year yield US5YT=RR hit 2.034 percent, a level last seen in March, Reuters data showed.

(Graphic - U.S. Treasury yield curve is flattening: reut.rs/2lb06sD)

Reporting by Richard Leong; Editing by Daniel Bases and Leslie Adler

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