The Treasury Market and the Fed Won’t Get Sidetracked by an Inflation SurpriseBy
Treasury curve flattening persists after latest CPI report
December rate hike ‘penciled in’ despite subdued price data
The dominant dynamic in the $14.2 trillion Treasury market can withstand whatever Wednesday’s inflation numbers say and whatever Fed speakers have to say about them.
Over the past year, the yield on two-year U.S. debt has marched nearly 70 basis points higher, compared to a paltry 12 basis point rise in its 10-year counterpart -- an intense so-called bear flattening of the yield curve.
Global economic resilience, buoyant financial conditions and a firming domestic labor market have traders anticipating the U.S. central bank will hike rates for the third time this year in December despite relatively subdued inflation, fostering a sustained rise in short-term bond yields. This week, Philadelphia Fed President Patrick Harker said a December hike was already “lightly penciled in.”
Meanwhile, demographic-linked demand from large, liability-driven investors, asset purchases and other unconventional policies by foreign central banks, along with limited supply of longer-term U.S. debt, have all contributed to a relatively muted rise in 10-year yields over the past 12 months.
Wednesday’s release of consumer price inflation data for October is forecast to show headline inflation moderated to an annual rate of 2 percent, while the core measure held steady at 1.7 percent year-on-year. The Federal Reserve’s preferred gauge of inflation, the personal consumption expenditure core price index, is even further away from the 2 percent goal. Most measures of price pressures that strip out volatile elements have decelerated in 2017.
If all goes as expected, “we’ll have another week of flattening,” said Ben Emons, chief economist at Intellectus Partners LLC. “The ECB conference on communication showed that they don’t want to surprise markets -- and the more predictable the message, the flatter the yield curve.”
The flatness of the inflation break-even curve shows little market angst about the kind of breakout in pricing pressures that would be conducive to a bear steepening of the yield curve, he added. In a bear steepening, the gap between two- and 10-year Treasuries widens thanks to a larger increase in the longer-term yields. In a bull steepening, the spread widens due to bigger decline in short-term yields.
But Morgan Stanley global head of interest rate strategy Matthew Hornbach warns that analysts may be over-optimistic in calling for a 0.2 percent month-on-month advance in core inflation -- the consensus estimate for each of the last 24 prints -- setting up for a rally in two-year U.S. debt should the core number fall short of expectations for the seventh time in its last eight readings.
“Anything that doesn’t point to a slam-dunk December hike would risk a bull-steepening of the yield curve, given the near-certainty with which investors talk about the December meeting and market pricing,” he writes.
The Federal Reserve, however, may have already conditioned market participants to look past any small misses in realized inflation. Implied odds of a December increase soared in the wake of a September dot plot that affirmed the Fed’s intention to deliver a third hike in 2017, as well as August inflation figures that broke a string of lower-than-anticipated readings of core pricing pressures.
An immediate return to underwhelming inflation results the following month only briefly dented market expectations of further tightening before year-end, prompting Nomura Securities to conclude that “a surprise downside miss would have to be significant at this point to delay the expected hike.”
“While previous downside misses have led to lower market expectations of a December hike despite a lack of convincingly strong inflation data, we and the market expect the Fed to hike in December, reflecting the FOMC’s apparent decreased near-term sensitivity to incoming inflation data,” writes Nomura chief economist Lewis Alexander.
To see what might shift the dominant paradigm in the bond market, don’t look at domestic affairs -- turn to China, advises Bespoke Investment Group macro strategist George Pearkes.
The deceleration in credit growth as well as potential inflection points for corporate profits, industrial production and purchasing managers’ indexes are cause for concern about the state of the world’s second-largest economy. That could prompt a flattening of the Treasury curve driven primarily by sinking long-term yields, according to the strategist.
“Chinese growth is perceived as being a huge driver of the recent global uptick; we think that’s simplistic but if that story taps out, risk aversion will create a long-end bid, in our view,” said Pearkes. “Capital flows have also moderated but there remains a significant desire to move domestic capital offshore.”