Thursday, May 7, 2015

Fed: Bond Bath
Fed officials are probably very confused right now. They all say that their policy is data dependent. Some of them have said that the decisions of the FOMC are also market dependent. The latest batch of economic data has been mixed, with some indicators on the strong side but many still on the weak side, as discussed below. In addition, the recent dramatic backups in bond yields and in the price of oil must be new concerns that they need to factor into their policymaking. In other words, they have quite a mess on their hands, which means that investors are also looking at a tricky situation right now. Here’s the Fed’s conundrum, and ours:

(1) Bonds. US bond yields have jumped recently. The 10-year Treasury is up from a recent low of 1.87% on April 17 to 2.26% yesterday. Everyone is blaming that development on the spike in Eurozone bond yields, particularly the surge in the 10-year German government yield from its all-time low of 0.033% on April 17 to 0.58% yesterday. That’s despite the implementation of QE by the ECB starting on March 9.

With the benefit of hindsight, the backup in yields isn’t a surprise. Yields simply fell too low at the start of the year on fears that plunging oil prices might trigger widespread deflation, especially in the Eurozone, and maybe cause another financial crisis if oil companies started to default on their debts. Now that oil prices have rebounded, those concerns are evaporating and yields are normalizing. I think it’s that simple.

In any event, the backup in bond yields is doing the same to mortgage rates in the US. That could stall the already lackluster recovery in the housing industry, which might explain why lumber prices are falling. So maybe the Fed should postpone its lift-off given the lift-off in bond yields?

(2) The dollar. Furthermore, global bond markets may also be responding to the possibility that the FOMC will start lifting interest rates sometime this year come what may, to show that they can do it. What’s confusing is that the trade-weighted dollar is down 3.5% from its recent high on March 13, suggesting that forex traders believe that the Fed won’t start tightening anytime soon. A weaker dollar would boost US exports and bolster inflation. How might the Fed’s next policy decision (or indecision) be influenced by developments in the bond and currency markets?

(3) Commodities. A weaker dollar tends to be associated with rising commodity prices, including oil prices. Sure enough, the price of a barrel of Brent crude is up 45% from this year’s low on January 13 to $67.52 on Tuesday. The CRB raw industrials spot price index seems to be bottoming now, led by rising copper, lead, and zinc prices. That should encourage the Fed to start tightening.

(4) Inflationary expectations. A weaker dollar also tends to be associated with rising inflationary expectations in the bond market. Sure enough, the spread between the 10-year Treasury yield and the comparable TIPS yield has widened from the year’s low of 1.54% on January 13 to 1.94% on Tuesday. So tightening now makes more sense than it did earlier this year when inflationary expectations were lower.

(5) Wages & confidence. There are finally a few signs suggesting that wages are rising at a faster clip. During Q1, ECI wages & salaries rose 2.7% y/y, the highest since Q3-2008. Average hourly earnings rose only 2.1% y/y through March, but by 3.9% during the first three months of the year at an annual rate. Is that enough for the FOMC’s doves led by Fed Chair Janet Yellen to commence with raising interest rates? Or will they argue that doing so too soon might abort the recovery in wages, which may still be frail?

(6) Economy. The rebound in gasoline prices is already making the evening news shows. The nearby futures price is up 79 cents since this year’s low on January 13 to $2.06 a gallon. That increase will offset some of the wage-related rise in consumers’ purchasing power, and chip away at their confidence. Has the weather-related ice patch during the first three months of the year turned into the spring’s soft patch? I am leaning toward the soft-patch scenario.

(7) Conclusion. Confused by all this? You are not alone. I’m sure Fed officials are also confused. Maybe that’s why we haven’t heard as much from them over the past week as we usually do right after FOMC meetings. My takeaway is that bond yields are getting mighty attractive, though the 10-year Treasury probably bottomed earlier this year at 1.68% and should trade between 2.00%-2.50% over the rest of the year. I remain in the one-and-done camp on the Fed’s lift-off, and wouldn’t be surprised by none-and-done.

Stocks, bonds, and currencies should mark time at current levels through the summer until the Fed is less confused and less confusing.
(Based on an excerpt from YRI Morning Briefing)

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