Relentless bond rally & signs of rate hikes slowing down

The FOMC meeting minutes showed that the Fed officials are considering slowing the pace of rate hikes. A few members also indicated that a switch to smaller interest rate increases could reduce the risk of instability in the financial system. Is this the signal that the Fed is ready to pivot?

Even if a majority of traders now expect the Fed to hike by 50 basis points in December (instead of 75bp), we should bear in mind that the US central bank keeps on shrinking its balance sheet (minus $207bn since mid-September). It will likely allow US$95bn of bonds per month to roll off its balance sheet over the course of 2023. 

This quantitative tightening poses financial stability risks if the Fed slams on the brakes even though the economy slows down. That's what risks tipping us into recession as evidenced by the yield curve inversion.

While the 10-year Treasury yield fell to 3.69% this week, the 2-year yield stayed around 4.47%, exceeding the 10-year note yield by as much as 78 basis points. This reliable predictor of US recessions has reached a level not seen since 1981.

In Europe, the yield on the German 10-Year Bund broke through the key level of 2% (down 2 basis points at 1.98%), testing a ten-week low. The French 10-Year OAT yield lost 5 basis points (2.43%).

All the bond segments lured inflows this week. Hence, investment grade corporate bond prices were up 0.34% in Europe (IBOXX € Liquid Corporates index down 12.04% YTD) and up 1.35% in the U.S. (IBOXX Ishares $ Investment Grade Corporate Bond Index down 16.71% YTD).

High-yield bonds jumped 1.23% in Europe (IBOXX € Liquid High Yield Index down 8.92% YTD). They gained 1.20% in the U.S. (Markit iBoxx USD Liquid High Yield Capped Index down 7.89% YTD).

Emerging debt in local currencies was up 1.16% (down 16.84% YTD) as the greenback weakened on the Fed minutes (dollar index down 1.21%).