As Turkish authorities refused the latest attempt to release a U.S. pastor in their custody the lira has weakened anew and that has a risk-off tone this morning that’s aiding Treasury prices. The 10-year is up 2/32nds to yield 2.86% and it’s clear emerging market concerns will dictate trading as we head into the weekend (more on that below). Also boding well for Treasuries was their performance yesterday. Despite a 1.5% gain in the Dow Jones Industrials, Treasuries managed to absorb the risk-on frenzy with little give up in yield. The 10-year Treasury lost 2/32nds in price while the 2-year was flat on the day. Perhaps the fixed income market assessed the conditions of the risk-on rebound—low-level US/China trade talks to resume later this month, and a Turkish Finance Minister investor call that met low expectations— as dubious and thus didn’t back-up more in price. In fact, markets that had been previously ailing stocks failed to hold gains to the close. Commodity prices finished in the green but off their best levels, and dollar weakness reversed in the afternoon. Given that it looks like the risk-on rally lasted all of one day it would seem fixed income investors had the better measure of things.
|Economic News||Copper Leads the Commodity Tumble||Market Rates|
Today we will try to address the reasons why long-end yields have failed to head inexorably higher and try to determine whether these catalysts for limiting yield back-ups will be long-lasting or merely a pause before the climb to higher rates begins. Recall that the 10-year Treasury hit it’s year-to-date high on May 17th when it touched 3.11%. It quickly fell to 2.78% on May 29th when the Italian’s elected a populist government that was thought could endanger the whole E.U. experiment and thus a flight-to-safety trade occurred.
While the Italian/E.U. scenario may still play out—see the recent blamestorming over the Genoa bridge collapse as caused by years of Brussels-led austerity budgets—the 10-year note yield stabilized in the summer months ranging between 2.80% and 3.00%. Keep in mind too this range played out in the midst of mostly solid-to-strong domestic economic numbers headlined by the strong 4.1% second quarter GDP.
If long-end rates couldn’t muster much of a rally in the midst of that bountiful GDP number, and a July CPI report that revealed a continued trend towards higher inflation, what is missing catalyst for higher rates? We suppose one could point to upcoming supply increases due to the gaping budget deficit, or to selling by foreign investors as retaliation over trade disputes. Alas, those factors are already well-known to the Treasury market but have had little effect on the long-end.
We think the primary limiting factor for long-end yields is the belief the Fed will continue to hike rates to a point that it eventually reverberates back into the U.S. via slower global growth and disinflation. To date, the Fed sees only strength in the U.S. economy and with their dual mandate of price stability and full employment they will hike 25bps in September and very likely again in December.
As we’ve already seen from the Turkish crisis the rate hikes to date—and the balance sheet reductions—are squeezing emerging markets and additional rate hikes will only exacerbate the situation as reduced monetary accommodation and liquidity will continue to pressure currency values and borrowing costs. If the crisis was isolated to Turkey it would be brushed off but the impact has spread to other emerging markets including the second largest economy in the world, China.
Take a look at commodity prices and the near bear markets some of them are suffering. Part of the commodity decline can be attributed to the stronger dollar—which will not relent until the Fed pauses—but much of the decline can be attributed to reduced demand as China —the largest user of commodity resources—slows its purchases. Look at copper, oil, zinc, lead, aluminum. Many of these key elements in economic demand are either in a bear market (down 20%) or close to it.
Emerging markets that are dependent on vibrant commodity demand face the double whammy of reduced revenue and increased financing costs as dollar-denominated debt becomes much more expensive to service in local currency terms. One defense that emerging markets can and will employ is to raise local rates to defend their currencies and to limit capital flight. Argentina is already well down this path with a recent hike of their official rate to 45%. With these high rates, growth and inflation have no choice but to wane. That slow growth and increasing financial stress in emerging markets is likely to eventually rebound to our shores which will filter into aspects of the domestic economy and slow our growth and dull inflationary pressures. Thus, the overseas problems that don’t directly impact the U.S. now will eventually come home to roost as long as the Fed maintains its rate hiking schedule and it looks like they’ll continue that schedule as long as the U.S. continues to post solid economic results.
Thus, the market sees the hiking campaign of the Fed as continuing until Powell and Co. see evidence of slowing in the U.S., but in the meantime, the hikes are already well-along the path to causing pain in overseas markets and that will eventually work its way back to the U.S. Hence, the long-run market view is that growth and inflationary pressures are likely to ebb rather than accelerate given the hiking intent of the Fed and the interconnectedness of the global economy.
Copper Leads the Commodity Tumble
The unrelenting strength of the U.S. dollar in the wake of Fed rate hikes —past and planned—began a decline in commodities of all stripes. Lately, however, the complex is suffering from reduced demand from China and other users. The industrial metals complex, led by copper, has suffered the greatest damage falling more than 20%. Copper is often given the moniker of PhD of the economy with its role in so many elements of construction and electronic assemblies. The original decline in June had origins in the stronger dollar but the subsequent collapse owes more to the ebbing demand story. Does the dramatic price drop portend more global slowing?