The Daily Prophet: Looks Like Bond Traders Didn't Get the Memo

Connecting the dots in global markets.

Things are looking up in the U.S. economy. The government on Wednesday revised higher its estimate of second-quarter growth to a very solid 3 percent rate. Friday's monthly jobs and manufacturing reports will only reinforce the notion that there has been no slowdown this quarter. So, how do you explain the bond market?

U.S. Treasuries were on course to deliver their best month in terms of returns since June 2016, with the Bloomberg Barclays US Treasury Index gaining 0.95 percent in August through Wednesday. If bond traders were really convinced that the economy was getting stronger, then demand for the super safe assets should soften. Here's something else: the yield curve, or the difference between short- and long-term rates, is shrinking. That typically happens when confidence in the economy is low, because traders don't expect growth to be strong enough to generate faster inflation that would erode the value of fixed payments over time. Indeed, a government report Thursday showed that the Federal Reserve's preferred measure of inflation -- the core personal consumption expenditure index -- rose just 1.4 percent in July from a year earlier, the smallest increase since 2015.

It would be easy to dismiss the signals the bond market is sending if it hadn't been so accurate in past years predicting sluggish growth and inflation and the slow pace of monetary policy tightening. And while the economy may have bursts of strength, most bond traders say the longer-term outlook is rather bleak. "Any back up in rates should be viewed as a buying opportunity," Michael Collins, the senior investment officer for fixed income at PGIM, said in an interview with Bloomberg Television. Going forward, 10-year Treasury yields will probably "spend more time below 2 percent than above 3 percent," he said, adding that late cycle economic indicators are starting to build while price wars are breaking out across most all industries. 

Besides low inflation, one thing many bond traders talk about when explaining why they are less than optimistic is the health of the consumer. Despite decent economic growth, consumers look stretched, and it's starting to show up in their spending habits. That's been on display in the recent housing data. Within just the past few weeks, reports have shown a drop in monthly new home sales, existing home sales, housing starts and building permits. All that came amid lower mortgage rates. Some would say that has more to do with tight supplies, but at 4.2 months the supply of existing homes as measured by the National Association of Realtors is in line with the average before the financial crisis. Perhaps more concerning is that the NAR said Thursday that its home buyer affordability index is at its lowest level since 2008, while the most recent University of Michigan consumer sentiment report showed that its index of buying conditions for houses is the lowest since 2011. 


August was tough for stocks, with the MSCI All-Country World Index spending most of the month in the negative column before a late surge on Thursday pulled it back -- barely -- onto the plus side. While the optimists are likely to say that just shows the resilience of equities, the pessimists would point out that the struggle only underscores how fragile the market is given that the economic data has come in very strong of late. The Citi Economic Surprise Index -- which measures data that exceed forecasts relative to those that miss -- turned positive this month after being negative for most of June and July. The takeaway is that stocks are struggling to find their next catalyst. Where that comes from is anyone's guess, as earnings estimates are already at historically high levels and the synchronized global upswing in the economy is largely baked into prices. A comparison of bearish and bullish S&P 500 Index contracts by analysts at JPMorgan found the implied probability of a 15 percent increase in the benchmark move over the next three months is effectively priced at zero based on data going back to 1928.


Enough with the bad news. The rally in risk assets can continue if you consider that the demand is a byproduct of all the cash that has been created by central banks in recent years to ensure the global economy doesn't slip back into recession and to avoid deflation. Even now, central bank balance sheets are expanding by about $300 billion a month, with all that new money being put to work in markets. Deutsche Bank Managing Director and International Economist Torsten Slok takes it one step further. He figures that on top of the cash from central banks, there's potentially an additional $150 billion that comes from households. He gets to that figure by multiplying the household savings rate with disposable income for the 27 Organization for Economic Cooperation and Development countries. He wrote in a research note that this can continue as long as inflation and interest rates remain low. "Low inflation and solid growth continues to be the sweet spot for global equities and credit," Slok wrote.

Canada's dollar is looking very attractive after the government said Thursday that the economy expanded at a 4.5 percent pace in the second quarter -- top among Group of Seven countries and the fastest rate in six years. The gains were the result of the biggest binge in household spending since before the 2008-2009 global recession. Canada's dollar was the biggest gainer among the major currencies, with a Bloomberg Correlation-Weighted Currency Index tracking the loonie rising as much as 0.89 percent. The surge in growth should help cement the chances the Bank of Canada will continue raising interest rates this year -- possibly as soon as next week -- as the nation’s economy nears full capacity in what is turning out to be the strongest growth spurt in more than a decade, according to Bloomberg News' Theophilos Argitis. He noted that Prime Minister Justin Trudeau's fiscal policies are having an impact, particularly tax cuts and enhanced child benefits that came into effect last year. 

Before U.S. traders can take off early Friday for the long Labor Day weekend, they must contend with the Labor Department's monthly jobs report for August. The median estimate of economists surveyed by Bloomberg is for another solid increase of 180,000 in nonfarm payrolls. But, as usual, that's only half the story. The August numbers are notorious for falling below estimates. In fact, they've disappointed every August for the last six years, producing an average miss of 44,000, according to the fixed-income strategist at BMO Capital Markets. Taking the data back even further, to 1997, shows that the report has a 75 percent probability of disappointing, with the average miss of 56,000 jobs, they found. Given that, it's surprising that the so-called whisper number is for an increase of 192,000 jobs. That means if the actual number falls below estimates it could still move markets even though everyone knows that it usually disappoints.  

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