The USD yield curve has flattened since Nov 2016 except for a small respite in June 2017. The main drivers have been the determination of the Fed to raise rates thus pulling up the short end and the persistent lack of inflation holding down the long end. This has raised a few concerns. Is the Fed moving too aggressively and in the face of data? Core PCE has fallen from late 2016 to a low of 1.3% in Aug 2017 but has since been trending up. Market pricing of inflation, the 5 year 5 year forward breakevens bottomed in June but have begun to rise in Dec 2017. Beyond the inflation beat in the US, inflation has also surprised to the upside in India (on food, not energy) and in Japan (broadly). Inflation could be important this year. Could inflation at last be recovering? The US treasury will be issuing more bonds in 2018 than in the last 8 years. JP Morgan estimates net issuance more than doubling in 2018 to 1.3 trillion USD. At the same time, China is said to be considering moderating its purchases of US treasuries. Coupled with the Fed’s normalization, this changes the demand and supply picture for US treasuries.

Whereas the 30 year treasury was an ineffective duration hedge for 2017 as the curve flattened, the 30 year could be an effective hedge for 2018. For a fixed income portfolio which is long the 2 – 4 year sector, hedging with the 30 year treasury would incorporate a directional curve steepener.