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The Bond Column

Weaker Data and Balance Sheet Strategy Flatten Yield Curve
Updated: 2017-05-29, 08:55:22 ET
Analyst: David Kelland

This week, Treasuries reluctantly sold off on the fourth day of the relief rally in stocks (Tuesday) only for yields, which move inversely to prices, to fall back down on the FOMC minutes one day later. The simplest story to tell is that U.S. economic growth is a bit sluggish and inflation has been missing on the downside. Those factors are helping to convince investors that the Fed's tightening cycle will be lower and slower and those expectations keep yields low and the dollar weaker. Lower yields and a flatter curve are hurting bank shares a little but boosting stocks on average. Jan Hatzius, Goldman's chief economist, is starting to call for more dovish Fed policy.

The economic data releases this week were a bit disappointing on balance. The biggest bright spot was the upward revision to U.S. Q1 GDP growth (1.2% vs. 0.8% consensus) but the economic data releases for the month of April were generally weaker than expected. New home sales came up short (569K vs. 605K consensus) as did existing home sales (5.57M vs. consensus 5.65M) and core durable goods orders (-0.5% m/m). The advance estimate for the international goods trade deficit will also be a negative for Q2 GDP. Michigan Consumer Sentiment for May was revised down to 97.1 from 97.7. The Atlanta Fed docked its Q2 real growth forecast to 3.7% SAAR from 4.1% and the New York Fed's forecast fell to 2.2% from 2.3%.

Given that there was supposed to be 'residual seasonality' in the GDP model that accounts for chronically weak Q1 growth, Q2 should be much stronger if the economy is not seeing a slowdown in the beginning of this year. The early data for Q2 is not too encouraging. Nevertheless, there are no obvious and imminent shocks that will tip the U.S. economy from sluggish growth into recession. The only two on the horizon are China's financial balancing act and forth in certain urban real estate markets, mostly in the Anglosphere. Toronto would be ground zero for the global real estate overvaluation.

The most significant news this week, however, was that the Fed is likely to only partially halt reinvestment of its securities portfolio near the end of 2017. Investors were mostly predicting that the unwinding of the Fed's $4.5 tln balance sheet would start around the end of this year, but there had always been the possibility that the Fed would simply cease all reinvestment. According to the latest figures, that would have meant over $400 bln of unwinding in 2018. The FOMC minutes, released on Wednesday, appeared to kill that possibility and the 2s/30s yield spread touched a fresh, post-election low of 160 basis points today. This is the relevant text from the May 2-3 FOMC minutes:

Under the proposed approach, the Committee would announce a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month. As the caps increased, reinvestments would decline, and the monthly reductions in the Federal Reserve's securities holdings would become larger. The caps would initially be set at low levels and then be raised every three months, over a set period of time, to their fully phased-in levels. The final values of the caps would then be maintained until the size of the balance sheet was normalized. Nearly all policymakers expressed a favorable view of this general approach.

On the subject of the flattening yield curve, St. Louis Fed President James Bullard noted this week that long-term rates have actually moved lower since the March rate hike. This was not the outcome that the Fed wants to see and it indicates that the market believes the Fed is tightening too much. While Bullard does not vote and might be the most dovish FOMC participant, his observations will not be totally lost on Minneapolis Fed President Kashkari and Chicago Fed President Evans (both are voters). Additionally, tightening at the Fed also tightens policy in China, according to former Minneapolis Fed President Kocherlakota. With inflation quiescent, the more important consideration for central bankers is probably financial froth and it is not clear that a majority of the FOMC members take that risk seriously. The upcoming holiday-shortened week will feature a lot of data that will tell investors how growth during the second quarter is evolving. 

- David Kelland,