NEW YORK (Reuters) - Passage of a long-anticipated U.S. tax overhaul has up-ended the bond market’s favorite trade of the year as yields on some long-dated Treasuries shot to their highest in months, but doubts that the tax cuts will fuel inflation have many investors confident the reversal will be short-lived.
The view that the U.S. Federal Reserve will keep raising short-term interest rates, even as inflation remains subdued, has made longer-dated Treasury bonds more appealing to own than short-dated ones. This has made so-called yield curve flattener trades - a bet that the gap between short- and long-dated bond yields will narrow - a profitable bet in the bond market this year.
Investors’ appetite for this trade drove the yield curve to its flattest level in a decade earlier this week.
However, a sharp reversal got underway as the tax bill’s passage became certain, paving the way for a bigger government deficit and more federal borrowing.
“It’s a great time to cash out,” said Brian Reynolds, asset class strategist at New York-based Canaccord Genuity.
Both Republican-controlled Congressional chambers have approved the tax legislation, and President Donald Trump is expected to sign it in the days ahead.
The Treasury market selloff pushed the benchmark 10-year yield up to nearly 2.50 percent, its highest in nine months and the 30-year yield to around 2.87 percent, a five-week peak.
Some analysts reckoned the jump in yields reflects investors demanding higher compensation, or term premium, in case the tax cuts stoke inflation and hurt longer-dated bonds. How long this prevails is an open question, though, given previous episodes of curve steepening in the last year have quickly faded.
“In other words, sharp term premium moves tend not be permanent,” Cornerstone Macro analysts said in a note on Wednesday.
In late afternoon trading, the spread between two-year and 10-year Treasury yields was 63 basis points versus 60 basis points on Tuesday and around 51 earlier in the week. Even with this week’s steepening, the two-to-10-year part of the curve has flattened nearly 63 basis points this year.
Curve flatteners are seen as likely to regain popularity in the long run due to a low inflation outlook and sturdy global demand for long-dated U.S. debt. In the short term, however, it may prove a choppy trade as investors gauge the bill’s impact.
“It’s hard to predict how the yield curve would behave in the short term. The biggest question is the timing and level of cash flows going to the government after tax reform,” Canaccord’s Reynolds said.
One factor is the mountain of corporate cash held overseas.
As part of the new tax code, U.S. multinational companies could bring back some of the estimated $2.6 trillion in business profits they have overseas and the Treasury Department could benefit from the taxes on the repatriated money.
Reynolds estimated the Treasury might receive as much as $225 billion in tax receipts in 2018 if the companies bring back all their overseas profits.
This means the government could issue fewer two- and three-year Treasury securities, pressuring these yields lower and steepening the yield curve into 2019, he said.
Independent government estimates suggest the tax plan could add at least $1 trillion to the $20 trillion in national debt in 10 years as the Treasury Department would ratchet up borrowing to compensate for shortfalls in tax receipts.
The degree to which the bill may spur both business investment and consumer spending, which could lift tax receipts and cap the rise in the deficit, is another key unknown for the shape of the yield curve going forward.
Still, the dominant view on Wall Street remains that the cut will provide only a short-term bump up in economic growth, and many analysts expect the longer-term curve-flattening trend to reassert itself in the year ahead.
“Accordingly, we maintain our conviction on curve flattening going into 2018,” Morgan Stanley analysts wrote in a note on Wednesday.
Reporting by Richard Leong; Editing by Dan Burns and Chizu Nomiyama