Treasuries reversed early losses yesterday to finish mostly in the green as a solid 2-year auction led hesitant investors back into longer maturities that had suffered over the previous two days. So far this morning, longer-end Treasuries are adding more gains, albeit slight, while the short-end is flat which means curve flattening is back after a two-day hiatus. Meanwhile, investors await June new home sales today. They will be looking to see if that series misses like existing home sales did on Monday. Sales of existing homes, which constitutes 90% of the market, fell for a third straight month in June, missing expectations and signaling that overall residential investment likely softened in the second quarter. With the exception of February, year-on-year sales have fallen every month this year. Rising mortgage rates have no doubt curbed demand, (30yr rate 4.77% now vs. 4.17% a year ago), but low inventory levels have also been a constraint. Expect escalating trade tensions to further exacerbate shortages of building materials, driving a wedge between supply and demand. Thus, housing looks like it will be a drag on economic output for the second quarter and likely the third quarter too.
|Economic News||2yr-10yr Spread Finally Steepens Some||Agency Indications|
Last Friday we remarked that the summer had been marked by so little volatility that the somnambulant Treasury market was setting generational volatility lows for its limited trading range. Well, that apparently was the kiss-of-death for such slumber because since then the market re-steepened from a variety of factors.
First, the market was awoken on Friday when President Trump tweeted and remarked in an interview that he wanted the Fed to back off the rate increases as it strengthens the dollar and makes the U.S. less competitive than it might otherwise be. That lifted longer-term yields on the assumption a more docile Fed is likely to allow more inflation to seep into the system. The countervailing thought is that the Fed will keep to its rate hiking schedule lest it appear they are buckling under presidential pressure. We think that’s the correct longer-term assumption but for now the comments sparked selling as the independence of the Fed comes under some presidential pressure.
The next bout of selling came as rumors circulated that the Bank of Japan, at next week’s meeting, will begin to prepare markets for an adjustment to its rate management of the Japanese 10yr bond. The central bank has been trying to keep the yield around 0% and the rumors that they might consider abandoning the peg sent yields “soaring” from 3bps to 7bps. Japanese officials denied any change to the rate peg is forthcoming but it does add a little more suspense to what was thought would be a sleepy summer central bank get-together. Also, it’s useful to keep in mind the average yield on the Japanese 10yr bond over the past five years has averaged 25bps, over the last ten years 0.68%, and the twenty year average is 1.08%. Thus, while loosening the peg might put some upward pressure on yields, the extent of flow through to higher Treasury yields is likely to be limited.
Consider too if the FOMC delivers, as expected, a ninth rate hike in September it will have matched the average rate hiking total dating back to 1985. The average of those hikes was 28bps versus the current 25bps so maybe we’re due for a tenth to make up for the difference but the point is that the tightening campaign is moving to a place that, in the past, has signified a pause. And if Japan begins the journey from QE to QT it’s not so much the impact it will have on rates that we worry about but the amount of monetary policy tightening that’s being applied in various forms across the globe.
Add to that policy tightening the continued rhetoric over tariffs and trade and the tit-for-tat retaliation that has only just begun and the second quarter GDP with a 4-handle seems certain to be the high water mark for this economic cycle as consumers, and producers pull forward activity to front-run the tariff escalation.
Thus, while we think with additional Treasury supply this week, and the expected huge second quarter GDP number on Friday that pressure can easily remain on yields. In the longer-run, however, we expect the flattening trend that has been in place for well over a year to re-exert itself with the cycle low of 24bps likely to be challenged as the Fed keeps its hiking pledge, especially in light of presidential pressure.
With front-end pressure continuing from expected Fed rate hikes, the long-end is likely to be constrained, especially if confidence wains from increasing tariff actions. In that regard, the Trump administration announced on Tuesday they would provide $12 billion in agricultural subsidies to farmers impacted by the early rounds of trade tariffs with China. While the announced subsidies are an attempt to placate an important constituency, they also highlight the fact that once trade wars are initiated, the ramifications are hard to fathom and certainly seem to conflict with the “trade wars are easy” characterization by the administration. That characterization will also be put to the test today as European Commission Chairman Jean-Claude Juncker arrives in Washington to appeal to Trump to de-escalate the trans-Atlantic trade fight over tariffs on steel, aluminum and potentially cars. Expect headlines from that meeting to dominate the Wednesday news cycle.
2yr-10yr Spread Finally Steepens Some
Just when the curve flattening trend hit a cycle low of 24bps, selling on Friday and Monday helped drive the gap between 2- and 10-year Treasury yields wider. In fact, the move was the biggest two-day steepening move since February. The initial move on Friday was spurred by comments of President Trump indicating the Fed should ease up on rate increases lest it undo the good things happening in the economy. Then, early this week speculation gripped markets that the Bank of Japan will soon tighten its rate guidance policy. That sent the 2yr-10yr spread from the 24 yield low to 33bps yesterday. Some of that early-week anxiety has eased, however, with spreads at 30bps this morning.
Agency Indications — FNMA / FHLMC Callable Rates