10-year Treasury yields rose about 2bps after this morning’s ADP Employment Change release showed more jobs were added in September than expected. ADP reported 230,000 new private sector jobs versus the consensus expectation of 184,000 and 168,000 in August. While the correlation between ADP and the Friday jobs number has been tenuous of late, it does boost prospects for the BLS report which is expected to show 181,000 new jobs. That being said, the only number in the upcoming labor market reports that could upset the Fed’s well-telegraphed plan to hike rates quarterly would be another leg higher in wage growth and that isn’t forecast with a month-over-month wage increase of 0.3% expected versus 0.4% in August. The labor market is operating with a strong level of momentum such that the only real impact the labor reports will have on the Fed for the next few months is that they resolve to continue with quarterly hikes into the first half of 2019, and move the fed funds rate through neutral (2.50%-3.00%)into clearly restrictive territory. We talk more about that and the implications for longer rates below.
|Economic News||Italian 10yr Yields Reflect Increasing Concern||Agency Indications|
The ADP Employment Report this morning provided a couple points of interest for us. For one, it is something of a preview of coming attractions with that being the September Employment Report on Friday. Another thing it provides a reminder that the labor market is cruising along with little in the way of near-term turbulence on the radar. That being what it is, when the government report is released on Friday the Fed is likely to check-off the box that says ‘labor market continues strong’ which puts another brick in the wall for a 25bps rate hike in December.
Since last Wednesday, we’ve heard and read a lot regarding the FOMC meeting, the statement, the forecasts, the press conference and post-meeting speeches from other Fed members. One of the things we’ve learned is that the idea the Fed may pause when it hits the so-called neutral rate (estimated most lately between 2.50%-3.00%) is looking less likely. First, we had the pre-meeting speech by previously dovish governor Lael Brainard who stated that it’s likely the Fed will need to hike beyond the neutral rate given the economic momentum generated from the fiscal stimulus provided this year (i.e., tax cuts, increased deficit budget spending). That was perhaps the canary in the coalmine that pausing at neutral was probably not going to happen.
The second thing we learned in that regard is the updated Summary of Economic Projections (SEP) left us a couple clues about their intent to keep hiking past the neutral point. One clear indicator was the unchanged long-run equilibrium level for the unemployment rate. It was kept at 4.5%, where it’s been for quite some time, and that’s despite expectations from the latest SEP that unemployment will bottom at 3.5% next year and in 2020. The rate is then expected to move to 3.7% in 2021 before returning to the long-run level of 4.5%.
When unemployment dipped decidedly below 4.5% last year, without the Phillips Curve prediction of increased wage growth and inflation, there was some thought the Fed would acknowledge that reality and move their estimate of NAIRU (non-accelerating inflation rate of unemployment) down to something closer to 4.0%. By not moving it a smidge in the latest SEP they are loudly declaring that they still believe a level of unemployment below 4.5% will eventually generate unacceptable inflationary forces.
Thus, the Fed seems intent to continue with quarterly hikes for as long as the unemployment rate remains under 4.5%. And if their projection is that unemployment will remain below that level at least through 2021 we’re likely to see rate hikes for quite some time. In all likelihood we get to 2.5% by the end of this year and then we can expect three more hikes in 2019 getting us to 3.25% as long as the economy doesn’t veer off the tracks.
Another hike is forecast in 2020 to 3.50% and that would clearly put us in restrictive territory, unless the neutral rate moves higher, and given the Fed sees inflation remaining docile— around 2.0% during this same time period — it’s not likely to move that much from the current 2.50%-3.00%. Clearly the Fed sees unemployment under 4.5% as having the potential to stoke inflationary embers and they are intent on smothering them, being good Phillips Curve disciples that they are. So another strong employment report will only add to their confidence that quarterly rate hikes are the proper course to follow.
As long as this is appears to be the playbook, investors are coming to the realization that the Fed’s inflation forecasts (around 2.0%) and economic forecasts (GDP trending down towards 1.8%) are reasonable and that’s likely to keep longer-term yields in check to a certain degree, even with increasing supply expected in the years ahead. If the Fed is hiking on the short-end while unemployment slowly climbs and inflation and economic growth trend lower what’s the big catalysts to long-term yield increases? Thus, we continue to see the 10-year in a range bound state, say something around 2.75%-3.25% and the 30-year similarly hamstrung around 3.00%-3.50%.
Italian 10yr Yields Reflect Increasing Concern
Global bonds were well bid yesterday, especially safe havens like U.S. Treasuries. The catalyst for the price behavior was the increasing concern over the new Italian governments insistence to increase deficit spending to help the economy but that raises the risk of running afoul of E.U. budgetary rules. The rhetoric between the European Commission and the Italian government is sharpening. The Greek crisis was small enough to not raise alarm bells too much but the Italian economy (3rd largest in E.U.) and debt outstanding (1st in E.U.) is another matter altogether. There’s likely to be a coming showdown between the new populist government and the elites in Brussels. As the rhetoric and accusations increase expect flight-to-safety trades into Treasuries to increase providing another measure of support.
Agency Indications — FNMA / FHLMC Callable Rates