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Fed Ahead of the Curve Now

14 June 2017 by Mark Holman

With the Fed tonight likely to announce its 4th hike in the last 10 years, and its 3rd in the last 6 months, we have been discussing how with recent softness in inflation, their determined path towards normalisation is finally getting them ahead of the curve.

Today should be an interesting day for this thesis given that we are also due to have the May inflation data coming out this afternoon, which should confirm the lack of inflation.

The Fed governors have been consistent in their guidance, that they are looking through this recent softness as temporary and that they expect economic activity and inflation to pick up in the second half; so it will be very interesting to hear the prepared remarks and press conference after the rate decision this evening.

We are also expecting some commentary on future balance sheet reduction; however, the detail on this is likely to come out later in the year. The message though will be one of very gradual and controlled reduction, which should be supportive to bond markets.

Putting all this together we think we have a Fed that is now ahead of the curve and no longer behind it, which is good news for the very long end of the yield curve. We note that 30 year treasuries now yield 2.85%, which is still 60bps higher than the 10 year. Ultimately we see this spread going towards zero as the Fed completes its rate cycle.

Having said that, we still feel that there will be upward pressure on the yield curve while the Fed normalises. Accordingly, despite this flattening tendency we are still holding off adding duration risk to portfolios; but if we did, the very long end of the Treasury market would be our preferred choice.

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