U.S. Bond Markets
· Surprisingly soft results from the ISM survey and continued deceleration in service sector wage growth sent the long of the US yield curve down last week. At the same time, continued strong employment growth data is driving expectations for one final rate hike, lifting money market rates. Charts 1-3.
· The result is some room for a rate increase at the front end of the curve at the expends of a deeply inverted middle of the curve. This writer is inclined to agree that a 25 or 50bps rate increase is likely at the next FOMC meeting. For the FOMC, the difficulty will be in sounding hawkish about the medium-term without generating expectations for further rate hikes. The goal will be to “talk up” the back end of the yield curve with assurances that rates will be restrictive “for some time”, but without ever defining “some time”.
· The market is making clear that the economy cannot sustain overnight rates of over four percent for long as real rates appear to be continuing their trend lower (Chart 4). At the 5-year maturity inflation expectations have been trending down since February and are now back to two percent (Chart 5). If tighter policy comes at the expense of future inflation expectations the Fed will have a dilemma on its hands as the long end of the curve will sag, further inverting the yield curve. At the 30-year maturity inflation expectations have held steady, but real interest rates are showing signs of heading lower (Chart 6).
· Meanwhile, sensing the Fed has lost its nerve, financial conditions have continued easing and corporate bond spreads have tightened substantially (Charts 7-8). Risk markets are poised to take off once the terminal rate is known with some confidence and assuming external conditions do not deteriorate further.
· If the FOMC is successful in talking up the long end of the curve, or achieves the same via policy intervention, there will likely be a period of uncertainty in financial markets. However, bank credit and non-bank leveraged lending will likely accelerate to provide support for economic activity and asset prices.
· The possibility of slower growth and lower rates has allowed investment grade corporate credit to outperform (Chart 9). Perhaps that situation can be dubbed “soft landing on a hard surface”. In the situation of a hard landing Treasuries would obviously outperform, while in a soft-landing high yield bonds would clearly be the big winner. In either case, performance of IEI and HYG are likely to diverge and one or the other will converge with LQD.
Inflation and Gold
· Inflationary pressure continues to ease as energy commodity prices decline and the pool of available labor supply sits at a structural bottom (Charts 10-12). The labor market cannot get any tighter and commodity prices were sky high so the first leg down in inflationary pressure was easy. The next step down will be more difficult than the first was.
· Gold prices, perhaps anticipating a top in real rates, continue to receive a strong bid even when real rates are rising. Recent movements higher have been accompanied by warning signals from the RSI, but prices have yet to pull back (Charts 13 & 14). Together these signals imply gold is preparing to make a very bullish move higher, with $1,875 looking like a good place to position the starting line for a run.
G-7 Bond Markets
· Japan’s yield curve continues to be the envy of the developed world. The BoJ’s recent adjustment has already started to reshape the curve and I expect further intervention will take place. The BoJ will continue manipulating until the shape of the curve looks like a textbook diagram and the steepness of the curve is appropriate for a strong yen policy.
· Canada and the US share the dubious honor of having the most inverted yield curves in the G-7 and the situation got worse last week. The yield curve in the UK is clinging to a flat slope with the level of the curve staying roughly the same while ripples across the curve affect the relative steepness of different portions.
· The yield curve in Germany got a lot uglier last week, with money market rates rising in anticipation of tighter policy and long-term rates sagging in anticipation of slower growth. Indeed, the 30-year yield is back down to November 1st levels with the policy rate 125 bps higher. Germany is suffering from the same yield curve “pivot” plaguing the U.S. and Canada.
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