Treasury yields are once again moving lower as the angst over an uncertain Brexit outcome grows, and a realization that the trade tussle with China is unlikely to see any real improvement at the upcoming G20 meeting. Add to that risk-off brew a Fed that still appears committed to quarterly rate hikes into 2019 and the curve flattening pressure continues. While the famous (or is that infamous?) 2yr-10yr spread hasn’t revisited its August cycle low spread of 18bps the 2yr-5yr spread has set a new low this morning at 7.6bps. And that action makes sense to us as short-end yields remain buoyantly tethered to the Fed’s near-term rate hiking expectations. The intermediate part of the curve, however, is starting to sense that the issues mentioned above combined with gathering global growth concerns will force the Fed to relent on their expected rate hikes by mid-to-late 2019 and most certainly by 2020. That has the bid on intermediate Treasuries running ahead of the rest of the curve and thus sending the 2yr-5yr spread to a new cycle low. We think the flattening bias continues which will also keep any upward pressure on 10yr yields limited, while rallies could push them towards 2-handle yields. Presently, the 10yr is yielding 3.08%, up 7/32nds in price.
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The saying goes that Wall Street climbs a wall of worry but the worry has reached the point that it is definitely sending stocks lower and by consequence Treasury prices higher. The list of things worrying the market is long but the latest bout of selling stems from the Brexit fiasco and the possibility that Prime Minister Theresa May could face a no confidence vote as early as Tuesday ending her tenure and sending the whole Brexit deal into disarray.
While negotiations have been going on more or less since the June 2016 referendum the actual deal agreed to by May, and put to her cabinet for approval, has drawn a firestorm of criticism. Without getting into the weeds it seems critics of the deal point to the Northern Ireland “backstop” arrangement with goods and services there tied to EU standards but without the UK or Northern Ireland having any say in those standards post-Brexit. That requirement was thought to be necessary by the EU in order to keep an open border with the Republic of Ireland, an EU member. Critics call this an affront to the UK’s sovereignty.
What looks apparent to us is that a Brexit deal securing the required Parliamentary approval is still a long way off with the May government hanging in the balance, and the March Brexit deadline looming. That uncertainty is just the latest bit of “worry” that the risk markets are grappling with. Add in the Italian budgetary conflict with the EU, the slowing global growth story from China to the EU, the uncertainty over a divided US Congress, and the list of things certainly seems daunting. And when the market senses that much uncertainty the default position is to take risk off and hunker down in Treasuries.
The question is whether the equity selling is just another correction that will be followed by a renewed rally with Treasuries once again facing selling pressure? We’re not so sure of that. The length of the recovery is nearing record territory, and the Fed—via Jay Powell’s address Wednesday night—still sounds optimistic about the US economy while acknowledging to some degree concerns with overseas growth. That implies the Fed is wanting to continue rate hikes at least into the first half of 2019.
That begs the question of how well the consumer can weather future rate hikes, and with the consumer comprising two-thirds of the economy, assessing their health is imperative to accurately forecasting overall economic health. Housing activity has been moderating for months and weekly mortgage applications have printed negative for four of the last five weeks and are down 2.8% from a year ago. Meanwhile, real average hourly earnings improved in October to 0.7%YoY versus 0.5%YoY in September but that still pales in comparison to real wage growth in expansions past. Thus, the consumer is still plugging along—see the decent October Retail Sales Report—but with modest wage growth and increasing interest rates the 3%-4% consumption growth in the second and third quarters looks increasingly doubtful going forward.
Also when you look at the PPI and CPI reports for October a troubling trend is apparent. PPI numbers were generally at or higher than expectations while CPI went the other way, generally at or lower than expected. The rub there is that increased input costs via tariffs and other trade-related increases are only partially being passed through to the retail level, if at all. That implies two things that don’t bode well: (1) Profit margins will be squeezed by companies unable to pass through higher input costs, and/or (2) Higher costs will eventually move into retail prices forcing the Fed to continue with rate hikes and forcing consumers to battle both higher rates and higher prices.
Part of the input cost conundrum is no doubt weighing on equities as well. That brings us to another tidbit of information and that’s the Fed’s Senior Loan Officer Survey for the third quarter. The results can be summarized by lending standards either being held the same or loosened but with declining demand across most loan categories. Thus, we see the opportunity for more risk-off angst and that should add to the bid in Treasuries with the 10-year possibly challenging a 2-handle yield once again.
Spread Between US & Europe Lending Rates at 18-Year High
The spread between unsecured lending rates in the U.S. and Europe is approaching a level not seen since the dot-com crash more than 18 years ago. The difference in borrowing rates stems mostly from divergences in monetary policy, both present and expected, between the Fed and other central banks. Given the economic slowing in Europe, Japan and China, coupled with UK and Italian political uncertainty the divergence is not likely to dissipate soon. If anything, this disparity is another indicator that additional rate hikes in 2019 will be increasingly more difficult for the Fed to engineer without something breaking either domestically or globally.