Treasuries are in rally mode as a confluence of events reiterates that what moves Treasuries doesn’t always stop at the waters edge. The Turkish Lira is off 5% this morning as President Erdogan threatens central bank independence and that has heightened emerging market concerns. Meanwhile, sluggish European data has those markets in risk-off mode and Italian debt is continuing to slide on the populist noises emanating from the EU’s largest debtor. We think the flight-to-safety rally, (10yr note prices are up 13/32nds to yield 3.01%), is not just tied to these singular events but also to the more fundamental thought that global growth may be moderating. Add in the uncertainty over both China trade talks and the North Korean summit and the rally may have some legs to it rather than being a one-day wonder. Away from the geo-political, investors await the minutes from the May FOMC meeting later this afternoon as they try to determine whether the Fed is truly leaning towards a four-hike 2018. We discuss the minutes and the global growth question in more detail below.
|Economic News||G10 Surprise Index vs. 10-Year Treasury Yields||Agency Indications|
As mentioned above, the key event for the week will be this afternoon’s release of the minutes from the May 2 FOMC meeting. Recall the statement was pretty much as-expected with little change from the March such that odds of a June rate hike didn’t change much after the statement’s release. What investors will be looking for in the minutes, however, is the discussion about rate hikes for later in the year. The March rate forecast clung to a three hike scenario for 2018, but it would only take one “dot” to have moved higher for the median to shift to a four-hike scenario.
The market has a three-hike scenario nearly fully priced in, so if discussions in the minutes seem to indicate increasing consensus towards a fourth hike that should pressure the short-end of the curve as it begins to price in that fourth hike. The long-end, however, is likely to react bullishly, or with no reaction, if it perceives a Fed intent on moving every calendar quarter with 25bps rate hikes.
Unfortunately, the Fed speak this week is not helping to clarify the matter. On Monday, Atlanta Fed President Raphael Bostic (voter) said he favors only three hikes this year and that “the yield curve is very present in all of our minds.” Meanwhile, Philly Fed President Patrick Harker (non-voter) said if he sees acceleration in inflation he could back a four-hike 2018 scenario. Harker has generally been on the dovish spectrum with a particular emphasis on the wage stagnation question. That leaves us thinking, despite his words above, he’ll remain dovish unless wage growth starts accelerating in the summer. In any event, more Fed speakers will add their voices to the chorus this week with Fed Chair Jay Powell getting in on the act on Friday.
We will add that while the Fed is domestically-focused, and inclined to continue raising rates every three months, as long as nothing “breaks” economically-speaking, there are things happening abroad that may reverberate back to the U.S. in the form of lower rates. Stress in Europe is increasing as Italy, and the largest debtor in the EU, grapples with a newly-elected populist governing coalition that while not seeking to leave the EU is likely to ask for concessions and other populist measures that are not likely to be well-received in Brussels. Yield spreads on Italian bonds have been widening and if the new government does come forward with demand for debt haircuts (rumors have one proposal at $300 billion), yield spreads will widen further and flight-to-quality trades into Treasuries will accelerate. That will be a source of strength for Treasuries and may hasten a flattening in the curve if the Fed continues applying its pressure on the short-end.
Another factor that may keep the long-end resilient is the strength in the dollar. The aforementioned news about Europe only adds to the positive dollar sentiment as well as the tightening posture at the Fed. Emerging market economies are already suffering adverse impacts from renewed dollar strength. Most emerging market debt is dollar-denominated and a stronger dollar only adds to the financing costs. Weaker emerging market economies, or unsettling news from them (see Erdogan above), will be another source of capital flight back to the relative safety of Treasuries. Also, a stronger dollar lowers import prices, and for the U.S. economy, that has a monthly trade deficit of approximately $50 billion, that will dent inflationary impulses and be salutary to long-end yields as well.
An argument against the dollar/inflation theory posited above is the increasing price of oil/gas. While that has an inflation impulse, the cost implication to the economy is much less today versus when we last faced $100/barrel oil. Also, with somewhat stagnant wage growth, increasing gas prices may work to slow consumer consumption and that has disinflationary and moderating economic implications while higher oil prices provide a positive inflation component.
In fact, the history since 2015 shows that increases in energy prices have generally flattened the 5yr-30yr curve as the specter of near-term inflation increases but without the prospect of more durable longer-term price pressures. Higher wage growth could alter that calculus but until that happens we would expect the trend since 2015 to remain with a flattening curve off increasing oil prices. We discuss that in more detail below.
G10 Surprise Index vs. 10-Year Treasury Yields
Over the last 3 1/2 years the economic outlook for the G10 nations has correlated well with US Treasury yields. As economic releases beat expectations, yields rose. Conversely, as G10 data disappointed, US 10yr yields trended lower. The correlation, however, has not continued in 2018. While the surprise index has declined since December, 10yr yields have moved above 3.0%. This is the type of divergence that has historically proven unsustainable. If releases continue to surprise to the downside the longer-term yield correlation should reassert itself. Will we look back wistfully at today’s yield levels?
Agency Indications — FNMA / FHLMC Callable Rates