Updated: 2017-01-16, 16:00:20 ET
The Interest Rate Outlook
Treasury yields declined this week as investors took advantage of relatively attractive yields to do some bargain hunting at the start of the year. While the gains were not all that large, the move lower in yields from Tuesday night to Friday morning was actually quite dramatic with the 10-year yield falling by 17 basis points during that time. The December Employment Situation Report, which was released on Friday and showed average hourly earnings growing 0.4% m/m, reversed the rally in Treasury prices and sent the bulls running for the exits.
Apart from the jobs report, which was mostly as expected except for the acceleration in wage growth, the U.S. data surprises were also positive. The ISM Manufacturing Index jumped to 54.7 (Briefing.com consensus 53.6) and the ISM Non-Manufacturing Index remained at 57.2 (Briefing.com consensus 56.6). Auto sales were very strong in December to cap a record-setting year but some analysts noted that carmakers used aggressive discounts to drive the volume.
In short, the U.S. economic expansion keeps humming along but the FOMC is virtually assured of staying put on rates at its 1/31-2/1 meeting. By the March 15 meeting, the Fed and investors could have some more clarity on the outlines of major fiscal stimulus bills moving through or having already been passed by Congress. Until then, Fed watching should be a mostly recreational pastime. There are a lot of things that can happen on the economic front and the fiscal/regulatory policy front. Also, Trump gets to appoint two members to the Board of Governors who will begin voting immediately following confirmation by the Senate. Listening to Fed policymakers now, particularly non-voting ones, with so much up in the air and so much time for the situation to change is probably a waste of time at best.
|Fed Fund Futures Rate Prediction||June 2017 (67%)||June 2017 (67%)||NA|
|10yr Treasury - 2yr Treasury||120 bps||125 bps||-5 bps|
|High Yield - 10yr Treasury||387 bps||401 bps||-14 bps|
|Corp A - 10 yr Treasury||106 bps||104 bps||+2 bps|
|10 yr Bund - 10 yr Treasury||-215 bps||-223 bps||+8 bps|
|5yr, 5yr Forward Inflation Breakeven||2.07%||2.05%||+2 bps|
The yield spread between the 10-year Treasury note and the 2-year Treasury note narrowed by five basis points to 120 bps this week. The spread had widened as far as 132 bps on December 15 from a low below 70 basis points during the summer of 2016 when the term premium went sharply negative. With the Bank of Japan's quantitative easing program having now morphed into "yield curve control" and the tapering of the European Central Bank's program on April 1, the supply of long-dated government debt is going to have less official demand. Fears of outright deflation in both the U.S. and eurozone have now subsided to trivial levels. With oil prices having stabilized, there appears to be little risk for the 2s/10s spread to revisit its 2016 low although if the Fed gets behind the curve and has to tighten rapidly, that could push the 2-year Treasury yield up sharply and narrow the spread that way.
The yield premium on high-yield debt fell to 387 basis points over Treasuries of comparable maturities last week as WTI crude stabilized in the low 50s. Much of the risk in the junk bond market lies in the price of oil because so many of the most at-risk borrowers are in the energy sector. The outlook for corporate America also brightened a bit as evidenced by a buoyant equity market and that should have supported higher junk bond prices as well.
Investment-grade corporate debt yields widened by two basis points to 106 bps over Treasuries with comparable maturities last week. Corporate spreads remain near very low historical levels despite increasing leverage at non-financial U.S. companies. After an eight-year economic expansion, investors could be forgiven for assuming that the good times will last forever or at least that they can sell before the next fellow. There are also questions surrounding the supply of investment-grade corporate debt in 2017 with certain tax proposals being discussed in Congress. A "destination-based cash flow tax with border adjustment" system would eliminate the tax advantages of debt over equity financing. Assuming that debt issuance would decline were such a tax reform to be passed is not a big leap. We have not yet seen estimates regarding the magnitude of such a decline in supply.
The 10-year German bund yield rose by eight basis points relative to the 10-year Treasury yield this past week to trade 215 bps below the Treasury yield. The economic data out of the eurozone last week was stronger than expected. Purchasing managers' indices for both the manufacturing and service sectors beat expectations for December and the headline consumer price index jumped sharply. Eurozone core inflation, however, has remained range-bound for months around 0.8%.
The expectation for five-year, five-year forward inflation rose by two basis points to 2.07%, remaining much higher than its pre-U.S. election level. The upward momentum in inflation expectations has ebbed in recent weeks and it may take fiscal action from the new Congress and Trump to push expectations significantly higher. Average hourly earnings growth of 2.9% y/y, reported on Friday, does indicate that upstream prices are rising and they should eventually filter down into the prices for goods and services.