Let's assume that you think the Fed will raise rates two more times this year, and for the sake of argument three times in 2018. It stands to reason that your forecast for two-year yields at the end of next year has to be about 2.5%-to-3.0%. The argument for this sequence of events seems fairly straightforward. The U.S. economy is growing—albeit not spectacularly—, unemployment is sub-5%, and the FOMC is anxious to put the era of super-loose monetary policy behind it. The key question, though, is what your corresponding forecasts for 5-year and 10-year yields are, because we're closer to a do-or-die moment for bonds and the Fed's “hiking cycle.”
I think we're looking at a four-scenario outlook.
1) The parallel flattener – In this scenario, the Fed raises rates about five times in the next 18 months, and two-year yields go north of 2%. The curve flattens, but also performs a parallel shift higher. Crucially, in this scenario 5-year and 10-year yields increase—substantially—but less so than the 2-year yield, which will soar as the Fed pushes ahead. In this scenario, the curve does not invert in the next 18 months, but it will be very flat at the end of it.
2) The Trump steepener – In this scenario the Fed also raises rates five times toward the end of 2018, but the economy improves faster than the Fed can keep up with. Presumably, this could only happen if we observed a serious “catchup effect” in terms of inflation and nominal growth and/or if the White House suddenly delivered on both infrastructure and a bullish—but not protectionist—tax reform. Needless to say that this scenario would be cold steel for bondholders across the curve, but especially for duration bulls.
3) The u-turn – In this scenario the Fed is spooked by the dramatic flattening of the yield curve in response to even a modest hiking cycle. As a result, the FOMC backtracks and shuts down the hiking cycle. Given the silliness being practiced at the BOJ and the ECB, I reckon they could just about get away with this by blaming their foreign colleagues, but let's face it; it wouldn't be a good look for Yellen and company. If this forecast is true, I have to assume that Spoos and Blues will fly high. EDs will soar, and stocks will continue to grind higher on the promise of extended low rates. 5-year and 10-year yields should push higher, and the curve should steepen.
4) The great inversion – In this scenario the Fed pushes ahead, but bond markets won't have it and the curve continues to flatten. It is important to understand here how quick the curve would invert if this is the case. Think about 5-year and 10-year yields, which are now at about 1.7% and 2.1% respectively. If the Fed moves further and the current trend persists, we're looking at an inversion as soon as Q1 next year. The main victim here has to be the stock market. From the perspective of the Fed, this scenario would signal a bold Fed, which is willing to suffer the slings and arrows of an inverted yield curve in order to achieve a good distance between itself and the zero bound.
