As the markets continue to digest the Fed’s intention to slowly unwind its $4.5 billion balance sheet (also known as quantitative tightening), the bond market has taken the news in stride. Perhaps the market doubts that the Fed can execute the unwind effectively. Perhaps it’s just a nonchalant response to Europe and Japan’s ongoing massive quantitative easing that has kept their interest rates at nearly zero.

In economic news, housing inventory remains in low supply and demand is strong. With housing prices rising amidst flat wage growth, experts are concerned that housing is becoming unaffordable. Something will have to give.

The Trump administration also provided some context as to their proposed tax overhaul. We like the ideas of corporate taxes being lowered. Stay tuned.

With the 10-year trading above 2.30% this week, we continue to be concerned about rising interest rates and so we remain biased toward locking in interest rates at still attractive rates.

Bond yields drifted gently higher this week in response to the Fed’s comments on the improving U.S. economy and its belief that this economy can absorb an increase in short-term rates.  The smart money’s on penciling in one more rate hike in December, bringing the short term lending rate from 1.250% up to 1.500%.  More importantly, the Fed also discussed its intention to unwind its massive bond portfolio. This wind down will take several years and the Fed has discussed the wind down formula very clearly to the marketplace in order to avoid another “taper-tantrum”. However, the wind down of a portfolio of this size is unprecedented as the Federal Reserve currently holds $4.5 trillion of US and mortgage bonds.  While we hope this will go smoothly, one cannot be sure given the massive void in the marketplace the private sector and other Central Banks will need to fill.

There are two reasons that both the equity and bond market have responded favorably to the Fed commentary this week, even in the face of increased interest rates and a less accommodative monetary policy. First, inflation remains low and there is a growing feeling among economists that a 2% inflation-growth rate may be too high.  This benefits stocks and bonds greatly.  Second, while the Fed is beginning to tighten, central bankers in Europe and Japan continue to buy bonds and other assets. These purchases continue to keep global yields low.

In other news, the U.S. and North Korean tension continues to escalate, but to date the markets have not been adversely affected by this potential scary geopolitical event.

Given the extraordinary technical nature of the large central bank’s unprecedented involvement in the financial markets, we remain biased toward locking-in interest rates especially now that the Fed has confirmed its intentions to move away from extreme monetary policy.  While we can make the argument for lower interest rates, we feel it is prudent to remain cautious while interest rates remain so low.

Mortgage and U.S. Treasury yields rose slightly this week in response to less-than-expected destruction from the double whammy of Hurricanes Harvey and Irma, in conjunction with improving inflation data. The markets continue to discount ballistic missile tests by North Korea with little to no negative responses to this geopolitical risk as evidenced by the S&P closing at a record high on Friday.

The big economic news this week was nascent signs of a pick-up in inflation. As written previously, the lack of inflation continues to perplex the Federal Reserve given the rate of unemployment of 4.500%, the longevity of our economic recovery, and the high prices of equities and real estate. The lack of inflation has kept interest rates low, which has benefited equities and real estate. It’s clear that Federal Reserve wants to continue to raise short-term interest rates to stave off a potential stock and real estate bubble, but it is less clear precisely when they will next hike rates.

At this time, we continue to remain biased toward locking-in interest rates given the improving economy, a potential rise in inflation, and attractive interest rates.

All eyes were on the disruptive weather caused by two major hurricanes: Hurricane Harvey which devastated Texas and Hurricane Irma which is about to hit Southern Florida as of this writing. Hurricane Jose is lined up behind Irma, adding another question mark to the level of potential destruction. Repair estimates for the destruction wreaked by hurricanes Harvey and Irma will be in the hundreds of billions of dollars. While one may think that these disasters hitting major cities would negatively affect the stock market, the temporary loss of revenue caused by these natural disasters will be offset by the major re-building efforts and should not impact US economic growth over the long term.

Inflation resistant data continues to perplex our Federal Reserve, and there were some comments from the Fed that additional interest rate hikes may be put on hold until the beginning of next year. With a combination of nearly full employment, high valuations on equities and real estate, and a slow, but steady growing economy, one would think inflation would be present. However, inflation readings to date have persistently come in lower than expected. Interest rates are the beneficiaries of these poor readings, as rates look to remain lower for longer.

With the 10-year Treasury yields trading under 2.100%, we are biased toward locking in interest rates given the attractive rates at the moment. We feel it’s much more likely that interest rates will rise rather than fall.

The combination of soft inflation data and a weaker than expected August jobs report continues to keep bond yields lower for longer.

Inflation, or the lack thereof, has been a conundrum to many economists. Increased consumer spending and an overall healthy job market usually lead to rising inflation, though this has not been the case during this past economic expansion. This lack of inflation may very well limit the Fed’s ability to raise short-term interest rates this fall. The Fed has raised short-term interest rates twice so far this year. A third increase is anyone’s guess at the moment, but soft inflation data does support keeping interest rates steady as the economy does not seem to be overheating.

The August unemployment data were disappointing. The Unemployment Rate ticked up to 4.4% from 4.3%. Within the numbers, it showed that both the U6 number and the Labor Force Participation Rate were unchanged at 62.9% and 8.6%, respectively. The conclusion from this report is that the labor market is healthy, but not as strong as expected.

With the 10-year Treasury note under 2.20%, we remain biased toward locking-in interest rates as both short-term and long term interest rates remain attractive.

Interest rates were flat on Friday after trading mildly lower throughout the week in what was a chaotic political week that included a heated Q and A between President Trump and the press as well as the resignation of controversial presidential advisor Steve Bannon.

The stock market sold off hard Thursday on some worse than expected earnings. The sell-off was intensified by the rumors that many of Trump’s senior advisors were unhappy with his remarks earlier in the week and were considering stepping down. The safe haven of bonds also benefited from the horrific terror attacks in Spain yesterday.

On the economic front, the Fed’s minutes registered their perplexion over persistently low inflation given the health of the economy and the low rate of unemployment. The lack of inflation should keep a lid on how high interest rates can rise – which is great for homeowners, business owners, and users of credit.

Consumer confidence was strong and further supported the notion that the economy is in good shape.

Given all of the above, we continue to be biased toward locking in rates as the 10-year remains near 2.20%

Volatility returned to the market this week as tensions between the United States and North Korea escalated.  The VIX index, which is known as the “fear index” and is used to measure near-term volatility, rose over 40% on Thursday in response to both the aforementioned geopolitical tensions and some disappointing earnings reports.  While bond yields have been drifting mildly lower, interest rates did not drop dramatically even with the uptick in volatility and the sell-off in equities.

Economically, lackluster reports both Thursday and Friday on inflation also did not push yields lower, which is somewhat surprising given that inflation is a major threat to bonds and the tame inflation numbers on the CPI and PPI usually correlates to lower interest rates.  However, the Fed’s intention to both continue to raise short-term interest rates and reduce its balance sheet have left the markets wondering how bond yields will respond to these policies. This has most certainly helped keep rates higher given the current circumstances this past week.

With mortgage bond prices near the 2017 highs, rates at the 2017 lows, and the 10-year yield at its recent low, we are biased toward locking in interest rates at current prices.

Longer dated US bond yields traded higher in response to a stronger than expected US jobs report.  However, the 10-year US Treasury is trading under 2.300%, and still priced very attractively.  There is concern from some prominent economists (Alan Greenspan is one of them) that global bond yields are artificially low, and that when interest rates finally move higher, volatility from both bonds and equities will be violent.

All eyes were carefully watching the U.S. jobs report which was out this Friday morning. The focus was on whether the report would confirm the Federal Reserve’s thesis, that job inflation is likely to be seen sooner than later.

The jobs report was a good one, with 209,000 jobs created in July, nicely above the 181,000 expected. The unemployment rate fell to 4.3% from 4.4%, the lowest since March 2001.  Average hourly earnings rose by 0.3%, in line with estimates and up from 0.2% in June. Year-over-year wages grew 2.5% compared with 2.4% in June. The U6 number was unchanged at 8.6%.  The U6 is total unemployed which includes all persons marginally attached to the labor force, as well as, the total employed part-time for economic reasons, as a percent of the civilian labor force. The Labor Force Participation Rate is at 62.9 from 62.8, still historically low.

However, job inflation continues to remain in check and that is one reason why the bond sell-off was mild. Given that the stock market is trading at all time highs, the current U.S. administration is pro-growth. The jobs reports continue to beat expectations. We are happy to see bond yields hang in there. However, we remain cautious (as we have for quite some time) and are biased toward locking in interest rates given the current economic and political environment.

Surprisingly, the stock market has continued to rally around the unpredictable political environment in Washington. Bonds yields have moved up as global central bankers continue to discuss the improving global economy, and the need to re-adjust the ultra-low interest rate policies we have all become accustomed to.

Economic growth improved in the second quarter, but the 2.6% reading combined with the 1.2% in the first quarter, is still reflecting a 2% annual growth rate. Given how much stimulus has been thrown at growth, one would think our economy would be doing much better. This low growth rate has benefited bond yields and is one reason we have not seen higher interest rates to date.

The inflation-reading Employment Cost Index rose 0.5% in Q2, from 0.6% in Q1, and measures workers’ wages and benefits.  From a year earlier, total compensation rose 2.4%, while wages were up 2.3% from a year ago.  The lack of wage growth continues to be a tailwind for low rates.  If wages don’t grow, inflation typically remains stagnant, as we have seen for a long time. This too is good news for Bonds.

The second and final read on July Consumer Sentiment came in at 93.4 versus the final read of 95.1 in June. The first reading for July was 93.1. This also supports Bond prices. The yield on the 10-year Treasury Note is well off the worst overnight levels and hovers near 2.30%.

We continue to believe interest rates can move higher and believe locking-in interest rates is a good idea given the posture of the Federal Reserve and their desire to move interest rates up.  However, we do believe the rise in yields will be gradual and somewhat predictable.

Bonds held up well in the face of a very strong jobs report, although interest rates did rise for the week in volatile trading. The muted response by the bond market to the June Jobs Report reminds me of the aphorism “buy the rumor and sell the news”.  Bond managers most likely hedged positions ahead of the June job report. The Fed’s Open Market Committee meeting notes were released on Thursday. These notes shined some light on the projected path of short term rate hikes, the Fed’s own view on inflation, as well as how the Fed plans to wind down its enormous balance sheet. Both the U.S. and European Central Banks have opined on the push for higher interest rates as the fear of deflation has subsided. With the German Bund ticking relentlessly higher, it makes it very difficult for U.S. yields to come back down. The German Bund yield sits at nearly two-year highs after the recent breakout. In the absence of a retreat in global yields abroad, it is hard to see much lower rates in the near term domestically.

Jobs Report

The June jobs report was robust with 222,000 new jobs created versus 185,000 expected. The Labor Force Participation Rate ticked up to 62.80%, but still remains at multi-level lows. However, wage inflation remains stubbornly flat and was a tonic for bonds. Inflation is the arch enemy of the bond market, and with no wage inflation one would think this to be the a reason for the lack of higher yields today, given the overall strong report.

We continue to closely watch bonds with an eye toward the ever so important line in the sand of 2.600% on the 10-year Treasury note. Our feeling is that it’s prudent to remain cautious and we are biased towards locking-in interest rates given the positive economic news that we are seeing out of both the U.S. and Europe.