Bracing for Fed normalization

Depending on how the market interprets Fed guidance at the upcoming FOMC on December 15/16, there could be some volatility in USD rates. A Fed hike of 25bps should come as no surprise. The market has already put the probability of liftoff in excess of 70%. Much scrutiny will be on the "dot plot" which should provide some guidance on the pace of normalization. While the market is too dovish on rates for 2016, the FOMC meeting need not necessarily trigger a sharp upward adjustment in USD rates. However, the follow up rate hike should make the intended pace of normalization clear to all participants. 

As such, there is scope for significant volatility in the front of the UST curve in the immediate few months. By contrast, longer-term USTs should prove more resilient to changes in monetary policy expectations. Longertenored USTs (5Y-10Y) are likely to sidestep the expected re-pricing of hike expectations. Beyond the immediate few months, however, inflation will be critical to watch for. Commodity prices are already down by more than 50% since mid- 2011. Any stabilization on this front, coupled with a tighter labor force in the US could turn inflation expectations quickly. Longer-term UST yields would then face greater upward pressure. For now, risk aversion in the leadup to the FOMC meeting reigns.