‘Tapering’ hangs above bonds in 2014

Following the Fed’s decision to taper in December, the US 10-year Treasury yield drifted upwards to just above 3 per cent by year-end, although since then yields have fallen back to a level roughly 2.85 per cent at the time of writing. From here, our expectation is that in spite of the lack of an imminent inflation threat and the low absolute levels of inflation in the US (and across the majority of the developed world), 10-year yields will rise substantially above the 3 per cent level through 2014.

One way of thinking about how far above 3 per cent they might go is to look at steepness of the yield curve compared with history. Currently, the US curve is already pretty steep between two years and 10 years (2s to 10s), with a yield spread of roughly 245bps. Historically, this part of the curve has never steepened beyond 300bps. If we accept this historical ‘peak steepness’ is unlikely to be exceeded, there is headroom for 10-year yields to rise by another 50bps, which would take us to the 3.3 per cent level.

At that level, the question then moves to the behaviour of the short end of the curve. Two-year Treasury yields have been in a range of 0.25-0.45 per cent for the past few months, and we believe they will remain anchored around these levels thanks to the Fed’s forward guidance to keep policy rates low.

This reasoning holds as long as the Fed can keep the market’s confidence that policy rates won’t rise any time soon, and this is where we come to the question of the credibility of forward guidance. For forward guidance to work, the central bank needs credibly to promise to behave irresponsibly later.

It is usually pointed out that traditional frameworks for monetary policy setting would suggest much earlier interest rate rises than the early-to-mid 2015 timing currently implied by forward guidance.

It is, however, worth remembering why central banks are deviating from traditional frameworks. Reasons might include an insurance policy against a relapse into deflation. But there is another reason: one key trigger for the global financial crisis was excessive debt levels, which do not feature much in ‘traditional frameworks’.

While household debt has already fallen quite a lot in the US, it remains much more elevated in the UK – which might prove the real test case for forward guidance. The UK housing market is famously sensitive to changes in interest rates. The Bank of England may therefore have the harder job walking this particular tightrope if the UK economy continues to accelerate.

Patrik Schöwitz is global strategist, global multi asset group at JP Morgan Asset Management