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Rate Brief

Updated: 2017-05-26, 16:00:21 ET

The Interest Rate Outlook

The U.S. Treasury complex rallied sharply last week but the yield curve flattened as investor expectations for Fed policy over the next two years changed very little. Wednesday's sharp sell-off in U.S. equities, the worst since last September, helped draw money into the longer maturities on the U.S. yield curve. Large speculators now have their longest position in 10-year futures contracts since December of 2007. The positioning of large speculators is generally seen as a contrary indicator, having properly predicted peaks for Treasury yields back in December and March. Large speculators had a record net-short position earlier this year.

The U.S. economic data was mixed but provided little basis for doubting that the FOMC will vote to hike rates at the June 13-14 meeting. The fed funds futures market is currently implying a 78% probability for such a move, according to the CME website. April housing starts missed estimates (1172K vs. consensus of 1255K) and March's number was revised down by 12K. Industrial production grew by 1.0% m/m in April ( consensus 0.3%) and March's growth was revised down by a tenth of a percentage point. The Empire Manufacturing Index missed forecast but the Philly Fed Index unexpectedly spiked. 

In related markets, WTI crude for July delivery rallied by $2.50/bbl. to close at $50.67/bbl., unwinding another chunk of the March/April sell-off in oil prices. The U.S. Dollar Index fell from 99.19 to 97.12, touching a six-month low. The S&P 500 fell from 2,390.9 to 2,381.7 last week, recovering most of Wednesday's big decline on Thursday and Friday.

Fed Fund Futures Rate PredictionJune 2017 (78%)June 2017 (74%) NA
10yr Treasury - 2yr Treasury95 bps104 bps -9 bps
High Yield - 10yr Treasury378 bps373 bps 5 bps
Corp A - 10 yr Treasury103 bps102 bps 1 bp
10 yr Bund - 10 yr Treasury-185 bps-191 bps 6 bps
5yr, 5yr Forward Inflation Breakeven1.88%1.92%-4 bps

The yield spread between the 10-yr Treasury note and the 2-yr Treasury note narrowed by nine basis points to 95 basis points after remaining steady during the prior week. The flattening of 2s/10s was largely a result of safe-haven buying in longer maturities, even as the economic data did not soften enough to warrant a sharp change of course at the Fed. It is worth remembering that sub-100 levels have traditionally signaled heightened risk of recession, but large holdings of Treasury and mortgage securities at the Federal Reserve may have reduced the usefulness for that rule of the thumb. Those Federal Reserve SOMA (System Open Market Account) holdings reduce the term premium and tend to keep the yield curve flatter.

The yield premium on high-yield debt widened by five basis points to 378 bps over Treasuries of comparable maturities. While higher oil prices were supportive of debt issued by energy sector companies, the heavy squall that hit markets on Wednesday pushed down junk bond prices even as Treasuries rallied and that widening was not unwound by the end of the week.

The investment-grade spread widened by one basis point to 103 basis points after narrowing by one basis point during the prior week. Investment grade spreads remain priced for low default rates, high recovery rates, and low new issuance. Corporate tax reform remains on the back burner until Congress can get something passed on healthcare.

The 10-yr German bund yield rose by six basis points relative to the 10-yr Treasury yield last week, ending at 185 basis points below the U.S. government security's yield. The prior week saw a narrowing of seven basis points. The economic data from the eurozone remains strong and GDP growth there was 0.5% q/q during the first quarter. The euro's strength and the narrowing of Treasury/bund spreads is a move that we see as supported by the economic data. The U.S. economy has been in recovery for two or three more years than the eurozone because of the sovereign debt crisis there and its second-round effects. This means that there is more of a cyclical tailwind of pent-up demand in the single currency bloc.

Market expectations for five-year, five-year forward inflation fell by four basis points to 1.88% after declining by the same amount during the prior week. Oil prices did move higher last week but the probability for large-scale fiscal stimulus remains limited and the Fed appears to be resolved to hike two more times in 2017, barring a material deterioration in the economic outlook.