BofA: Curve Flattening: Hawkish Fed And Policy-Error Concerns

Bank of America note that “the sharp 2-/10-Year and 5-/30-Year curve flattening is driven by two factors: (1) higher front-end rates with hawkish Fed pivot, and (2) declining back-end rates with lower terminal or neutral expectations. The higher front-end driver is clear: inflation concerns. The back-end driver is less obvious.” They attribute the back-end rate drop to “Fed policy error concerns and technical factors (offside positioning, challenging liquidity).”

• “The Fed policy error concerns are likely driven by the potential for hikes into a slowing economy and the following: (1) Omicron impact, (2) supply constraints, and (3) sensitive risk assets. Recent Fed communications suggest the Fed is not sufficiently bothered by any of these to stop the hawkish tack. To re-steepen the curve, it likely needs to see inflation peaking, which is probably quarters away.”
• “The hawkish Fed pivot suggests risks of further curve flattening and further pull forward of rate hikes. This shift will likely present headwinds to risk assets, especially if the Fed starts planning quantitative tightening (QT).” They suggest investors “don't fight the Fed: pay March '22 FOMC OIS, short 2-Year Tsys, position for higher real rates and cheaper U.S. Tsys”