Weak PPI Aids Treasury Rally

Sep 12, 2018

Treasuries are trying to rebound after selling yesterday pushed yields to the upper bounds of recent ranges. The positive tone was helped along this morning when August PPI came in under expectations. Overall and core PPI were off –0.1% versus +0.2% expected and that sent the year-over-year prints below expectations as well (2.8% vs. 3.2% expected and 2.3% vs. 2.7% core). CPI tomorrow will give us a better look at consumer-level inflation but the weak PPI is setting the market up for a bond-bullish report.  That being said, with the Treasury set to sell 10– and 30-year issues today and tomorrow any rally is likely to be limited, but for now the 10-year is up 5/32nds in price to yield 2.96%. While the 3% level could still be challenged, the imminent landfall of Hurricane Florence seems likely to muddy the economic waters for a time as business disruptions, wind and water damage and restoration costs leak into economic releases in the months ahead. While it’s not likely to impact the economy to a material degree it will add complications when interpreting results. If past experience is any guide, however, the Fed will look past the impacts as temporary and keep to their established schedule which we think is quarterly hikes until we get to the neutral rate (more on that below).


  Economic News


U.S. job openings rose in July to a fresh record and the biggest share of workers since 2001 quit their positions, adding to signs of labor-market strength that may push wages higher. Those are the findings from the latest Labor Department Job Openings and Labor Turnover (JOLTs) report. While the report, being July data, is slightly dated it does provide the Fed with a few more nuggets of data to assess labor market health and what they’re likely to deduce is that the labor market is getting tighter and that’s likely to keep the Fed ‘s proverbial foot on the rate-hiking pedal.


The headline number in the report is the number of positions waiting to be filled which increased by 117,000 to 6.94 million versus a pre-release estimate of 6.68 million. The July result is an all-time high and beat the upwardly revised 6.82 million unfilled positions in June.  Job postings exceeded the number of unemployed people by 659,000 in July, the most since the report began in 2000. That gap between job openings and unemployed may help explain why wages rose in August at the fastest pace since 2009 as employers struggle to find available, qualified workers.


Meanwhile the Quits Rate (those leaving positions voluntarily) rose to 17-year high of 2.4% (job leavers divided by all workers) from 2.3% as 3.58 million Americans quit their jobs versus 3.48 million in June. The Quits Rate is a favorite metric at the Fed. When the rate increases it implies more workers have increased confidence in the job market sufficient to walk away from their jobs in search of better opportunities.


This report, along with the August jobs report and the wage gains noted therein, will provide the Fed plenty of fodder to stick to quarterly rate hikes for the foreseeable future. The consequence of that is market expectations for a December rate hike have risen from a lowly 20% chance in June to over 70% following the Friday release of the August jobs report.


Assuming the Fed does get its four hikes in 2018 that would put the fed funds rate at 2.25%-2.50% at year-end. In relation to where that stands vis-à-vis the so-called neutral rate (the rate that is neither accommodative nor contractionary), a couple Fed models have the neutral rate pegged around 2.75%-3.00%.  Thus, one or two hikes in 2019 would put us in the neighborhood of that mystical figure. There is some thought that that might be a natural place to pause the hikes and assess how inflation and the labor market react to the rate hikes done  to date.


The issue with that scenario is the neutral rate is not a static number. It can drift and right now it’s probably drifting a bit higher given the bump in recent inflation readings. That could imply that 2019 could see three or four rate hikes, just like this year.  Obviously that would put the fed funds rate above 3% which will require longer-term yields moving above 3% lest we experience an inverted curve, and that opens its own can of worms.


There are plenty of Fed officials on record as not wanting to hike into an inverted curve but there are others that have expressed the thought that this time could be different. In any event, while 2018 hikes have been relatively obvious, 2019 will be another matter altogether which each successive hike coming with more handwringing and brow mopping from some Fed officials concerned over inverted curves and neutral rates, etc..


We are of the opinion too that as long as the market perceives the Fed is intent on maintaining a quarterly hiking schedule, it will keep yield pressures on longer-term bonds contained. Thus, we still see a flat to inverted curve as the most likely scenario given the present momentum in the economy.  At the same time, a quarterly hiking schedule will keep the dollar strong which will suppress most import prices which will aid in keeping inflation gains at bay. The strong dollar will also keep the pressure on emerging market currencies and if that risk spreads sufficiently it will reverberate back to the U.S. in the form of flight-to-safety bids and general slowing in global economic output. The point in all this discussion is that each successive rate hike next year will become increasingly more challenging to engineer without adverse fallout, and given the practical nature of Fed Chair Jay Powell, a pause at some point in 2019 seems to us as a likely event.




Market Update  Odds of December Rate Hike Increasing


The pop in average hourly earnings noted in the August jobs report has also put a pop in the odds that the Fed will follow the expected September rate hike with another in December.  As the graph shows, the odds of a December rate hike (to 2.25%-2.50%) have been rising from an unlikely 20% level in June to more than 70% following the August job numbers and the pick-up in YoY wages to 2.9% noted in that report. That wage increase represents a nine-year high and investors interpreted that as a signal the tightening labor market is finally being felt in higher wages. That, in turn, is likely to keep the Fed’s foot on the rate-hiking pedal until we get closer to the mythical neutral rate, which some Fed models peg at 2.75%-3.00%. Assuming two more hikes in 2018, that would imply two more hikes in 2019 before the Fed may entertain a pause.

Odds of December Rate Hike Increasing



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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