Interest rates remain under pressure due to ongoing positive economic data and signs of potential inflation. Those pressures were fueled earlier in the week by a misleading report that China may slow or halt purchases of U.S. government securities which pushed yields higher on Wednesday before retreating when the accuracy of the report was called into question. Chalk it up to “saber rattling” by China as the U.S. continues to try to negotiate better trade deals with the Middle Kingdom. While bonds did wind up rallying after the report was confirmed to be inaccurate, one must be reminded how delicate the balance is between our trading partners. China owns over $1.2 trillion of our outstanding $6.3T in treasuries which represents 19% of the pot. Why does China buy our bonds? China buys our bonds so that the U.S. keeps buying inexpensive manufactured goods from China. It is a situation where both countries have mutually benefited for a long time and disrupting this relationship could have severe consequences.
The key economic reports this week were the Producer Price Index (PPI) and Core Consumer Price Index (CPI) readings. While the PPI reading was tame, the CPI readings, which strips out volatile food and energy, saw its largest increase in 11 months with year-over-year CPI increasing from 1.7% to 1.8%. With the pro-growth policies in place, the threat of inflation is real and if inflation rises unexpectedly it will negatively affect bond yields and interest rates. Couple the threat of inflation (actual confirmation that inflation is rising has not been verified) along with record property and equity markets leaves the Fed confronting some difficult decisions in the coming months with respect to how to raise interest rates gingerly while still protecting the economy from a potential bubble(s). It will be interesting to see how the new Fed chairman responds to these potential challenges.
While at the time of this writing the all important line in the sand of 2.62% on the 10 Year Treasury Note remains intact, we are mindful of the fact that the probability is that interest rates go higher rather than lower. Therefore, we continue to remain biased toward locking in interest rates which are still very attractive historically at current levels.
With the first week of trading in the books, the Dow, Nasdaq, and S&P 500 all closed at record highs. Short-term and long-term yields continue to compress with the so-called 2-year to 10-year gapping by only 50 basis points. A flattening yield curve normally suggests the economy is moving into the later part of the economic cycle and that less risk should be taken. However, animal spirits remain alive and well.
On the jobs front, there was some concern after Thursday’s ADP report blew past expectations that the December Jobs Report would come in “extremely hot” much to the demise of bond yields. The top-line report data fell short of expectations with 148,000 jobs created versus 188,000 expected. The unemployment rate came in at 4.1%. However, the November jobs numbers were revised higher and the body of the report showed some positives such as average hourly earnings rising 0.3% from November’s 0.2% and increasing 2.5% year over year, above the 2.4% annually in November. Should wage earnings move higher, rates will continue to move higher as well.
There are varying opinions on where the US is in the economic cycle. Certainly the massive central bank stimulus over the last decade has distorted asset prices and has kept yields artificially low. True price discovery has become difficult to quantify. The pro-growth argument is supported by synchronized global economic growth, pro-business tax reform, and low global interest rates. For those less bullish, there is concern about the flattening of the yield curve, the Fed’s determination to tighten rates, and the expansion of the price earning ratios on stocks, as well as low-cap rates in real estate and increasing consumer debt.
With unemployment at 4.10% juxtaposed against low wage and consumer inflation readings, the Federal Open Market Committee (FOMC) made good on its promise to raise rates in 2017 with its second rate hike. The overnight lending rate, known as the federal funds rate, increased to 1.25% -1.500%, and was increased by .25%. Government expectations are for a growing economy in 2018 which may be amplified with the Republican Tax Reform Plan which is just about finalized. The conundrum remains that while inflations is beginning to show signs of increasing here and in Europe, it still remains persistently below the Fed’s 2% target. Soft inflation data has been a boon for bonds. As we have written previously, should inflation data heat up, you should be prepared for a quick rise in interest rates both domestically and internationally.
Bonds traded well this week even in the face of a roaring stock market, pro-business tax cuts, and an increase in lending rates. One reason was the benign comments out of the FOMC and Federal Reserve Chair Yellen on the path to normalizing interest rates – slowly and carefully.
With the 10-year trading in the 2.300% to 2.400% range in light of the many positive factors including tax reform, strong corporate earnings and global synchronized economic growth, we remain biased toward locking in interest rates at current levels.
Treasury yields and stocks rose Friday in response to a better than expected jobs report. The U.S. added 228,000 new jobs in November which beat economists’ forecasts of 195,000 jobs. Unemployment remained at 4.15%, while average hourly earnings rose .2%, lower than the expected .3%. Wage growth has remained elusive during this nine-year long economic expansion, and the lack of wage inflation has been a main factor in keeping interest rates lower for longer.
The Fed will speak next week with a nearly certain probability of announcing a rate increase in the overnight lending rate. The market will be closely watching how long term interest rates react to this rates increase as concerns of a flattening yield have been receiving some attention as of late.
We continue to remain biased toward higher rates and are advising clients to lock-in interest rates at these current levels.
This week saw another powerful equities market rally as the prospects of a U.S. tax cut, synchronized global growth, and low-inflation boosted equities higher. Bonds suffered a bit as interest yields for mortgage rates and government debt rose. While there are signals that inflation may be brewing, the Federal Reserve’s preferred measure of inflation, personal consumption expenditures price index (PCE), continues to run below its 2% target, and is a main reason that yields have not jolted higher.
The big news this week was the tax overhaul which is likely to pass before Christmas. The proposed tax reform will benefit corporations and earnings, and is one of the main reasons our stock market is roaring higher. The added fuel of these tax cuts on top of an improving economy should pressure bonds to rise at some point. There are simply too many positive economic factors at work, including unemployment at 4.00%, tighter employment pool of skilled workers, high real estate and equity valuations, and finally, strong signals from the Federal Reserve that it is now time to attempt to normalize interest rates. However, higher mortgage interest rates can be supported in a growing and robust economy combined with overall lower tax rates.
With the 10-year U.S. Treasury near 2.400%, we remain biased toward locking in interest rates given the many positive economic readings that we are seeing.
Mortgage bonds and long-term Treasuries ended the week unchanged after a volatile week of trading. Thursday saw a strong rise in equities with the House passing its tax reform bill. The next step is the Senate where it will meet some resistance from Republicans based on the current iteration of the tax reform bill. However, for the moment, Mr. Market likes what it sees.
Inflation remains muted but small signs of an increase in inflation data are emerging. If inflation does rise, bond rates are likely to rise as well. As long as inflation remains soft, mortgage and bond rates will continue to benefit from these benign readings.
We also continue to monitor both short-term and long-term interest rates. The so-called flattening of the yield curve continues to weigh on investors’ minds, as well as hurt bank profitability. Compression of the yield curve is often a sign of a slowing economy. With mortgage rates near support levels, we continue to be cautious on interest rates and believe locking-in interest rates is the right call.
Bonds ended the week on a sour note as yields rose in response to improved economic growth from Europe. They were also impacted by comments out of the European Central Bank (ECB) that a firm deadline on European bond purchases is needed. Government bond purchases have been an elixir for the marketplace and have been instrumental in pushing down global bond yields. A move away from this policy will result in higher interest rates.
The only economic report due for release today is Consumer Sentiment. While the reading came in lower than expected, the reading remains high and supports the the belief that people are upbeat about the economy.
With the 10-year Treasury touching 2.400%, we remain biased toward locking in interest rates. We are also closely monitoring the flattening of the yield curve (the relationship between short term and long term yields). The inverting of the yield curve has been a historical predictor of a slowing economy and is a margin squeeze for banks and lenders.
This past week was filled with a packed economic and corporate earnings calendar which included the nomination of a new Fed Chairman (Fed Governor Powell), the first rate increase in the UK in a decade, the proposed outline of the new GOP tax bill, and the monthly jobs report. Also, many major corporations announced positive third quarter earnings. Below is a summary of the key events of the week:
Fed Governor Powell is viewed as a safe pick for the Fed and is likely to maintain Janet Yellen’s and Ben Bernanke’s policies albeit with an inclination toward less regulation. The announcement came as no surprise and rates trended slightly lower into the announcement. It is believed that Mr. Powell will continue the slow path rates hikes approach.
In the U.K., the Bank of England raised short-term interest rates for the first time in over a decade. This was in response to a recent return of mild inflation and a synchronized improving global economy.
Back in the U.S., the GOP unveiled its new tax proposal, which focuses on business tax rate deductions. Inevitably, there will be winners and losers in this plan. At the moment, it appears that cities with expensive real estate will be at a disadvantage due to the new caps on property tax deductions and the reduction in the size of the mortgage deduction.
Finally, the October jobs report came in under expectations with 261,000 new jobs created versus 300,000 expected. Due to the late summer hurricanes in Texas and Florida, this report has been discounted as these storms caused many temporary distortions. However, it is worth reporting that income remains flat which is a strong indicator that inflation is not existent in the economy at this time.
The 10-year Treasury yield headed lower this week and is trading at 2.333%. Given all of the positive economic data, robust earning, and possible pro-business tax plans, we are pleasantly surprised by where interest rates are holding, but we are maintaining bias toward higher interest rates.
Interest rates continue to move higher in the face of strong corporate earnings (rates rallied surprisingly today), a rip-roaring stock market, and indications out of Washington that the pro-business tax reform is moving along positively.
On the economic front, the Bureau of Economic Analysis reported Gross Domestic Product (GDP) grew by a solid 3%, an overall good reading, and yet another reason for bond yields to move higher.
Across the pond, the European Central Bank Chairman Mario Draghi clarified how the ECB will move forward with its own slow and steady reduction in Quantitative Easing. The ECB chairman’s tone remains dovish (bond friendly) and he has committed to keep monetary stimulus going at least through September of 2018. These bond-friendly comments did help to steady bonds late in the week.
With the 10-year Treasury breaking through 2.400%, we remain biased toward locking in interest rates. There are simply too many positive economic and corporate reports coming out of Wall Street to gamble on interest rates going lower. We are also carefully watching the 10-year to see if it breaks through the all important 2.62% level.
Mortgage and U.S. government bonds rallied Friday morning reacting to softer than expected retail sales combined with an anemic Consumer Price Index inflation reading.
Regarding the CPI readings, the Core CPI reading (which removes food and energy due to their volatility) came in at a meager 0.1%. This reading was well beneath expectations of 0.2%. This left the year-over-year CPI at 1.7%, well below the 2.00%-plus that the Federal Reserve would like to see on CPI. The Fed also closely analyzes the Personal Consumption Expenditure (PCE), which is also trending well below the Fed’s target inflation rate.
While the Fed continues to believe low inflation readings are transitory, ongoing low inflation readings are a strong sign that interest rates will remain low for the near term. While many economists believe a December rate hike of .25% is still on the table, the Fed’s reason for raising rates has more to do with rising asset prices and high valuations on some types of real estate. After 10 years of low interest rates, the Fed would like to move the short terms interest rates back to historically normal levels. A return to normalcy does make sense given the strong jobs market, stable inflation, and all-time highs in U.S. equities.
Given the weak inflation data, we are biased toward floating interest rates, but we advise to be very cautious in doing so.