This increase is not due to higher expectations for short-term rates or long-term inflation, but rather based on the uncertainty component of nominal yields, the term premium. This comprises the inflation risk premium (uncertainty of expected inflation) but also embodies the yield-dampening effects of Quantitative Easing (duration extraction). The recent rise in the term premium (+60bp YTD) for the 10-year maturity to 30bp - in positive territory for the first time in over two years – implies investors are pricing in higher inflation uncertainty and pricing out parts of the QE effects. The bond markets in their current early post-pandemic euphoria have thus increasingly embraced the tapering narrative and are now testing the Fed's commitment to long-lasting loose monetary policy.
An unusual steepening pattern, with diverging trends at the extremities of the curve. The repricing of the term premium has led to a significant steepening of the US curve (3M-10Y spread from ~80bp to ~140bp). However, the underlying pattern is unusual, with a sharp rise at the long end seen in parallel with a decline at the short end.
US T-bills with a maturity of three months are trading at only 4bp after 9bp a month ago. The US money market is currently experiencing dislocations due to the coincidence of excessive liquidity and a growing lack of safe collateral. So while all investors are closely watching the long end, the hit might come from the short end. Most recently, collateral squeezes have already caused distortions on longer repo rates (i.e. 10Y repo rate). But the much bigger risk comes from the increasing scarcity of short-term collateral (US T-bills) which has a much greater importance for the repo market. Indeed, the supply of US T-bills supply could tighten significantly in the coming months. The US Treasury has already started to reduce its USD1.7trn cash buffer and it could shrink to USD500bn in the next few quarters under the new stimulus plan. In the process, the monthly issuance of US T-bills is expected to decline to around USD100bn.
In turn, the reduction in the US Treasury's cash balance will cause bank reserves to rise. The combination of reduced T-bills supply and the increase in bank reserves will lead to further downward pressure on ultra-short money market rates. Effective Fed Funds rates are already trading at only 7bp. The SOFR (reference rate for the repo market) is trading very close to zero. Money market rates sliding into negative territory is now quite possible. But would it be such a big deal?