Updated: 2017-03-28, 16:00:20 ET
The Interest Rate Outlook
U.S. Treasuries made significant gains last week as markets were preoccupied with the vote on the American Health Care Act, the Republicans' response to Obamacare. The prioritizing of the AHCA was meant to make passage of permanent tax reform easier and so its failure has been interpreted as a setback for some of the supply-side reforms that financial markets have priced in since the November 8 U.S. election. The gradual fading of hope for the passage of the AHCA in the House -- not to mention its scant chances in the Senate -- drove down Treasury yields, U.S. equities, and the greenback. Oil prices failed to generate a meaningful bounce from their early March sell-off and that helped to keep junk bonds under pressure.
The U.S. economic data was minor but new home sales jumped to their second-highest level of the recovery (592K) in February. New home sales are considered more important than those of existing homes because they are accompanied by greater purchases of durable goods, landscaping services, etc. The durable goods orders data for February was mixed with the headline number at 1.7% m/m (1.3% Briefing.com consensus) and the ex-transportation reading at 0.4% m/m (Briefing.com consensus 0.7%).
There were several Fed speakers last week but they were all regional Fed presidents and many were not even voters. Fed presidents tend to speak very frequently, diluting the value of any given piece of communication, but they make up only five of the current ten votes on the current FOMC. Once President Trump appoints two more members to the Federal Reserve Board (and the Senate confirms them), the regional Fed presidents will have even less influence.
|Fed Fund Futures Rate Prediction||June 2017 (54%)||March 2017 (51%)||NA|
|10yr Treasury - 2yr Treasury||114 bps||117 bps||-3 bps|
|High Yield - 10yr Treasury||389 bps||373 bps||16 bps|
|Corp A - 10 yr Treasury||104 bps||104 bps||1 bp|
|10 yr Bund - 10 yr Treasury||-200 bps||-206 bps||6 bps|
|5yr, 5yr Forward Inflation Breakeven||2.22%||2.12%||10 bps|
The yield spread between the 10-year Treasury note and the 2-year Treasury note narrowed by three basis points to 114 bps last week. The flight-to-quality nature of the Treasury market rally as U.S. equities sold off contributed to better gains at the longer maturities. While there has been an uptick in risk aversion in the United States, it is far from being enough to prompt serious changes to the outlooks of Fed policymakers, so the two-year note yield has remained firmer than the other maturities. Fed officials continue to delay serious discussion about the unwinding of the Fed's asset purchases from the early post-crisis period and the maintenance of the bloated balance sheet is having a flattening effect on the yield curve. Until a plan is in place to roll off some of the balance sheet, there is unlikely to be significant widening of this spread.
The yield premium on high-yield debt widened by 16 basis points to 389 bps over Treasuries of comparable maturities last week. WTI crude remained below $49.50/bbl. all week and that kept junk bonds under pressure. The U.S. retail sector is also going through a very difficult period as suburban malls see stores close and analysts fear that the whole business model could come crashing down. All eyes now turn to corporate tax reform, which could create big waves in the high-yield market if Washington, D.C. puts an end to the tax deductability of interest payments on corporate bonds.
Investment-grade corporate debt yields were unchanged at 104 basis points over Treasuries with comparable maturities last week. Weakness in U.S. stocks was not enough to intimidate holders of investment-grade corporates although continued risk aversion in equity markets would be expected to eventually filter into securities higher up in the capital structure.
The 10-year German bund yield rose by six basis points relative to the 10-year Treasury yield last week to trade 200 bps below the U.S. government security's yield. The March purchasing managers' indices for the eurozone ran at 71-month highs for both the manufacturing and services sectors. Those readings in the PMIs correspond to 0.6% q/q GDP growth and so optimism continues to improve among economists that the eurozone is turning the growth corner. The European Central Bank isn't taking any chances and many policymakers are assuming that this recent jump in headline inflation is only transitory and will fade throughout the year as the year-on-year energy-price comparisons become less flattering.
The market expectation for five-year, five-year forward inflation rose by ten basis points to 2.22%.