• The Fed were planning a succession of rate rises.
  • Data disappointment brings that schedule into doubt.
  • Mixed messages from the Fed are misleading markets.
  • The US yield curve reflects frustration with Trump’s lack of progress.

A yield spread refers to the difference between the yields of two fixed income securities. One can compare two similar maturities across markets, say France over Germany at the same maturity point or one can evaluate the spread in one market across a specified portion of the underlying yield curve. Here, I consider the 2-Year 10-Year spread in the US Treasury market.

Yield spreads measured between different maturities on the US Treasury curve has historically been taken as a good indicator of how market players judge the economy to be performing and its prospects.

Treasury Spreads

Source: US Treasury Primary Dealers, Spotlight Ideas

The yield difference between the 10-Year and the 2-Year Note declined at the close of trading last Friday to 75 bps. This matched the low, booked on July 8, 2016 for the past 5-years. However, one should be aware that this spread has traded at negative levels in the past; i.e. the yield curve was inverted in 2000, (low -35 bps), 2005 and 2006.

Such extremes are line with difficult economic conditions and reflect the expectations of market participants. With so many speakers from the Federal Reserve (Fed) adding a comment virtually every day, often expressing a conflicting opinion it is no wonder the market may appear confused.

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While one section of the market has assumed the Fed was laying the groundwork for a rate hike in the very near future others have interpreted recent data differently.

Here, admittedly in a superficial manner I focus on two key economic metrics; GDP growth and consumer price inflation or CPI.

The US economy expanded an annualised clip of 3.0% in Q2 2017, well above a preliminary reading of 2.6% and beating market expectations of 2.7%. It is the strongest growth rate since Q1 2015 Increases in personal consumption expenditures (PCE) and in non-residential fixed investment were larger than previously estimated.

In contrast, CPI in the US stood at +2.7% in February and yet declined to 1.7% in July. As such the less hawkish Fed watchers sense that the short end of the yield curve has been sold off much too aggressively and the curve should steepen again.

On Tuesday, September 5th Federal Reserve Governor Lael Brainard suggested that inflation has not hit the Fed’s 2.0% annual target (price stability) over the past five-years. She added

“…In that case, it would be prudent to raise the federal funds rate more gradually, …”

Brainard is currently a voting member and is regarded as a leading dove within the Fed. She is often at odds with the hawkish members who would prefer the central bank to continue to raise rates despite low inflation. They fear that the Fed is too far behind the curve and believe it’s better to move proactively to ward off the risk of an inflationary spurt down the road.

However, I think we should give Brainard’s remarks a slight overweight as she has been frequently seen as being tightly aligned with the thinking of Fed Chairwoman Janet Yellen. At the end of the day, Do not forget, Yellen has the only voice that really matters.

The Fed had virtually signalled one rate hike this year and three next year. However, if low inflation proves not be a transitory factor then the Fed may determine it should navigate away from this course. Whatever the President’s misgivings about Fed policy, no one can argue that Janet Yellen is not pragmatic and a realist.

Given the financial markets as indicated by Fed Funds Futures are expecting only one rate hike over the next year I would think that the 2/10 spread at +75bps is too narrow and a period of readjustment may well be in order with a retracement back to +86 bps or +90 bps not to be dismissed.

Against that view I should concede that the 2/10 spread has trended lower for much of the year and even with the US economy growing, the market majority have priced the spread to replicate the recessionary conditions of 2008. I see the recessionary pricing as a real signal of frustration of the inability of the Trump administration to deliver his pro-growth economic legislation through Congress. Instead of fixating on undoing his predecessor’s “Affordable Health Care Act” or hunting the so called “Dreamers” in US society, it would be better if tax reform and infrastructure enhancement was centre stage. Sadly, after the impact of Hurricanes Harvey and Irma there will be no option other than rebuilding.

 

Only time will tell if the US Treasury curve has lost its power of prognostication. After all, can it be as accurate as ever following a decade of quantitative easing and yield curve distortion?

I think of it is as regarding the forex market as providing the fast-muscle twitch reaction to data and Fed-speak. Equities ride a wave of emotion and individual earnings news. Whereas it is Treasuries that cut through the noise and demonstrate a greater sense of strategic evaluation.

Stephen Pope