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Rate Brief

Updated: 2017-02-24, 16:00:17 ET

The Interest Rate Outlook

U.S. Treasuries traded somewhat lower this week and the yield curve flattened a bit although the market was rather resilient given the fundamental developments during the week. The producer price index, consumer price index, and retail sales for January all handily beat economists' expectations. Housing starts and building permits surged as well, as did the regional manufacturing activity surveys. The CPI rose 0.6% m/m ( consensus 0.3%) and the core CPI was up 0.3% m/m ( consensus 0.2%). Retail sales increased by 0.4% m/m in January ( consensus 0.1%) and December's growth was revised up to 1.0% from 0.6%. Retail sales excluding automobiles jumped by 0.8% m/m ( consensus 0.4%) and December's change was revised up to 0.4% from 0.2%. Industrial production came up short but that was entirely due to lower utility output from seasonally warm weather. 

U.S. housing starts ran at a seasonally adjusted annual rate of 1246K in January ( consensus 1220K, prior revised up to 1279K from 1226K) and building permits were issued at a 1285K SAAR ( consensus 1230K, prior revised up to 1228K from 1210K). The producer price index jumped by 0.6% m/m in January ( consensus 0.3%, prior revised down to 0.2% from 0.3%) and the core PPI rose 0.4% m/m ( consensus 0.2%, prior revised down to 0.1% from 0.2%).

If the economic data was not bearish enough for Treasury prices, the 30-year TIPS auction on Thursday tailed by almost five basis points, meaning that the high yield was almost that much higher than where the when-issued market anticipated it to be. The S&P 500 tacked on 35 points to 2,351.1. The biggest headlines from the Fed were Fed Chair Yellen's semi-annual Humphrey-Hawkins testimony. She sounded more hawkish than her usual self, saying that the FOMC would assess conditions at "upcoming meetings" (not ruling out the March 15 meeting for a rate hike). She also said that the neutral rate of interest is slowly moving higher rather than just saying that it is very low, as she has in the past.

The old adage is that the most bullish thing a market can do is go higher on bad news and, from that perspective, the market acted very bullishly. Nevertheless, Treasuries remain in a range and so it would be difficult to say that Treasuries rallied when all of the stars were aligned against them -- just most of the stars. We still view the Treasury market as showing an uninspiring bounce from its low on December 15, 2016.

Fed Fund Futures Rate PredictionJune 2017 (75%)June 2017 (67%) NA
10yr Treasury - 2yr Treasury121 bps123 bps -2 bps
High Yield - 10yr Treasury371 bps372 bps-1 bp
Corp A - 10 yr Treasury104 bps106 bps-2 bps
10 yr Bund - 10 yr Treasury-214 bps-212 bps -2 bps
5yr, 5yr Forward Inflation Breakeven2.16%2.12% -4 bps

The yield spread between the 10-year Treasury note and the 2-year Treasury note narrowed by two basis points to 121 basis points this week. Fed Chair Yellen's testimony before the Senate Banking Committee (Tuesday) and the House Financial Services Committee (Wednesday) was received by markets as hawkish and that helped to flatten the yield curve. It was also noted by some analysts that the Fed forecasts are not pricing in any fiscal stimulus, which implies that the number of 2017 rate hikes could be greater than three if legislation were passed soon. The Republican party's slim majority in Congress means that doing so will require skill and a lot of luck.

The yield premium on high-yield debt fell by one basis point to 371 bps over Treasuries of comparable maturities this week. An extension of recent highs in the stock market and steady oil prices contributed to higher appetite for credit risk.

Investment-grade corporate debt yields narrowed by two basis points to 104 basis points over Treasuries with comparable maturities this week. Investment-grade spreads remain near historic lows but funds continue to see inflows. The market consensus for any tax cut plan that eliminated the interest deductability of corporate debt is that such a move would not affect existing debt. One should therefore assume that corporate issuance will increase in anticipation of an agreement, particularly if an agreement becomes more likely. That may not dent corporate bond prices much though, as the increase in supply would be seen to precede a long drought of issuance.

The 10-year German bund yield fell by two basis points relative to the 10-year Treasury yield this week to trade 214 bps below the U.S. government security's yield. The economic data out of the eurozone continues to improve but the French presidential election in April still looms large over debt of the eurozone periphery. The European Central Bank released the minutes from its January 19 meeting. Policymakers showed little concern about increases in inflation measures at the Governing Council's meeting. The low in oil prices was in February of 2016, so the year-on-year inflation data should moderate after February 2017. Policymakers judged there to be some room for deviation from the capital key to limit the amount of debt purchased with yields below the ECB's deposit rate (currently -0.40%).

The expectation for five-year, five-year forward inflation rose by four basis points to 2.16%,