Treasury prices are moving higher this morning but the action is less about the State of the Union address and more to do with yet another weak manufacturing print from Germany. Talk is moving from whether there will be a recession in Europe to just how severe it might be. We discuss that topic in more detail below. Domestically, the State of the Union didn’t leave much of an impact on our markets. With divided government and a heightened degree of political dysfunction, promises and bold plans are not likely to hold much water so we move to the next big event. That could be the February 15th deadline for congressional conferees to reach agreement on government funding lest we lurch back towards another shutdown. While the funding legislation being cobbled together is not likely to have wall funding it may be crafted in a way that all sides can claim some measure of victory allowing us to move on to other matters. One can hope, right? Meanwhile, the Treasury auctioned $38 billion in 3-year notes yesterday with strong results despite yields that were hovering near the day’s lows at 2.50%. That rate compares to a yearly high of 3.04% back on November 8th. The successful auction speaks to investor demand despite low yields and that portends well for the $27 billion in 10-year notes to be sold today and $19 billion in 30-year bonds tomorrow. Investors appear convinced the Fed will be on the sidelines for the foreseeable future and with many uncertainties hanging in the balance from trade talks to global growth concerns it seems the better part of valor is to take the yields the U.S. Treasury is offering and live to fight another day.
|Economic News||2yr-10yr Yield Spread Flattening Stalls Out||Agency Indications|
A week ago the Fed delivered a three-pack in dovish surprises. They removed the forward guidance phrase regarding future rate hikes making it clear such hikes were now in question. They also inserted the word “patience” as it regards the pace and timing of future rate hikes just to reiterate their change in policy. Finally, they issued a separate statement to make clear the tapering of the balance sheet could be altered (read slowed) due to economic or other conditions as the committee determines. This was a walk-back of the oft-repeated autopilot reference to balance sheet tapering that helped spook the market in December. The post-meeting press conference by Chair Powell kept the dovish tone going. All of that dovishness put a boost into stocks while the 2yr-10yr Treasury curve has steepened 4bps with short-end yields rallying a bit more than long-end yields.
While the stock market took the news of the Fed moving to pause mode as bullish, the bond market was a little more circumspect. One would initially think a Fed pausing at 2.50%, and possibly done with its hiking cycle, might add a dose of inflation premium to bonds. That is, if the Fed steps back it allows the economy to gather itself after slowing in the fourth quarter and regain some of that lost momentum. Instead of yields backing up since the meeting, however, they have mostly held ground with yields actually dipping a bit.
Could it be the market took the Fed’s newfound dovishness as a “what do they know” moment? In that regard, part of the story could be the slowing in Europe. Italy has entered a modest recession after printing two straight quarters of negative GDP. More concerning is that Germany and France are showing distinct signs of slowing too. European retail sales dropped 1.6% in December for the weakest print since May 2011. Certainly a lackluster holiday shopping season to be sure. The regional breakdown saw German spending decline -4.3% on the month and -2.2% yearly. As the largest economy in Europe, it’s hard not to conclude the trade war has begun weighing on consumers and that transition is particularly relevant because spending is a key component to the region’s overall economy. Just like in the U.S. when confidence ebbs, it can do so rapidly and dramatically.
The latest round of PMIs on the Continent have not been pretty either. France reported both services and composite measures in contractionary territory at 47.8 and 48.2, respectively, for January. Italy is facing a similar circumstance, with manufacturing sentiment also sub-50 and reinforcing the thought the mild recession may prove longer-lived than the small declines in real growth initially indicated. Meanwhile, on the British Isle the average U.K. citizen is getting whiplash between competing Brexit scenarios but in all of them it points to a protracted and not especially encouraging outlook. It’s latest PMI readings were below expectations but clinging to expansionary territory, but just barely (services at 50.1 and composite at 50.3).
In the U.S. the latest ISM reading for the services sector in January is still in expansionary territory, but off expectations. The overall index fell from 58.0 to 56.7 versus a 57.1 forecast and the lowest since July. New orders fell from 62.7 to 57.7 but other measures such as order backlog, supplier deliveries, and inventory change were mostly in-line with December numbers. In a sign, however, that seems to confirm the softening in Europe mentioned above, new export orders fell from a 59.5 reading to 50.5, the lowest print in two years. So, while the January ISM was a decent read on the services sector in the U.S. it does point to overseas weakening along with a moderation of activity stateside.
While we await more domestic information that has been held up because of the shutdown, the Fed is probably feeling pretty good about its decision to pause and let the previous nine hikes continue to work through the economy. With China, Japan and Europe in decided slowdowns it seems only reasonable to conclude the U.S. can weather that for only so long.
2yr-10yr Yield Spread Flattening Stalls Out
The flattening in the 2yr-10yr Treasury yield spread has been relentless as shown in the graph. As the Fed engineered nine 25bps rate hikes the short-end of the curve followed the fed funds rate higher while long-end yields held steady or retreated in the face of moderating global growth. The final dip to 10bps happened in the wake of the FOMC’s hawkish December meeting. With the Fed now dovish, and signaling a pause, the curve has steepened, a bit, but remains in a 10-20bps range. While an inverted curve is unlikely without another rate hike, long-end yields show no desire to rise given the slowing global economy. In sum, we may be stuck with this flat curve for awhile.
Agency Indications — FNMA / FHLMC Callable Rates