Treasury yields are grinding slightly higher this morning as hopes for averting a trade war spring anew and that’s driving a risk-on mood across Asia and Europe. The 10-year yield is off 6/32nds to yield 2.95%. That level is the 40-day moving average and may provide some support against a higher rate move. Yesterday, Treasuries found a bid that brought 10-year yields as low as 2.899%, before moving back above 2.90%. The move lower in yield stemmed from Italy’s new Prime Minister Giuseppe Conte promising in a speech to the upper Senate chamber a host of populist measures from a “universal basic income” to immigration restrictions. The Senate subsequently voted approval to the program and that will be followed by an expected yes vote today in the lower Chamber of Deputies. That vote will launch western Europe’s first populist government and a real challenge for the EU and the ECB. In the meantime, the renewed positive outlook on trade will get tested this weekend with the G7 meeting in Canada but Treasury yields may find it tough going next week with new supply of 3yr, 10yr, and 30yr bonds announced. The net new supply amounts to $44 billion, the highest since February 2013, so one can expect some pressure on yields, absent, of course, any risk-off political events transpiring but the odds of that happening are not insignificant.
|Economic News||European Economic Surprise Index Continues Lower||Agency Indications|
Investors are trying to come to grips with a handful of disparate issues: (1) a U.S. economy that after a modest first quarter seems to be accelerating in the second quarter which has been the trend over the past several years; (2) but the European economy seems to be slowing some and that’s before we concern ourselves with the political changes being wrought in Italy and Spain; (3) a Fed that will be raising the fed funds rate next week and is closing in on a near neutral rate position, and thus is seeing its margin of error shrink in regards to future policy choices; and (4) the possibility of trade wars erupting into something that does have the potential to slow global growth.
That stew of competing issues complicates investment decisions as it’s clear we don’t have the global economy heading in the same upward trend that was its character last year. Also, with contentious trade talks escalating, the accord between the EU, U.S., Canada, Mexico and China has deteriorated creating another dose of global uncertainty regarding the economic outlook going forward. The G7 meeting of world leaders this weekend in Canada is likely, if the G7 meeting of finance leaders last weekend was any indication, to be more a case of G6 plus the U.S.. The body language and comments coming from the meetings may give us an indication of whether international tensions are calming or rising.
Meanwhile, the Fed will be raising the target fed funds range next week to 1.75%-2.00%. If the U.S. economy continues thriving through the summer expect the Fed to raise again in September to 2.00%-2.25%, with a December option to raise again. Other central banks, however, are already making noises they would like to see the Fed pause given the strains 2% overnight rates are placing on other economies. The central bank of India commented yesterday they hoped the Fed would pause, and other emerging market economies that have been battered recently due to recent dollar strength are also hoping the same thing.
So the period in which the Fed’s rate-hiking campaign has been generally on autopilot is soon coming to an end. With the EU economy softening, and political turmoil building with tit-for-tat tariffs being exchanged between the world’s largest economies, and with emerging economies already straining under the six hikes already administered by the Fed, expect a more contentious discussion by the FOMC in September and certainly in December regarding rate hike decisions. For now that leaves us with a short-end still in a bear market reflecting the pressure of upcoming hikes while the long-end is more range bound given the concerns noted above.
That leaves the curve flattening trade that has been the trend over the past year firmly in place likely through the summer and probably into year-end. The 2yr-10yr spread has been as low as 40.2bps (May 31) and is currently hovering just over this at 41.9bps. We expect the month-end low to be challenged as we move through the rate hike next week while the 10yr trades between a 2.85% - 2.95% range.
While the trading this week is being driven more by overseas events and the political wrangling both in Europe and in the U.S., over trade wars, two reports yesterday did confirm the solid state of the U.S. economy which as we alluded to earlier makes a rate hike next week a done deal. The ISM Non-Manufacturing Survey for May rebounded from a small decrease in April and while the 58.6 print was off the 59.9 peak in January, it represents a healthy bounce and easily beat the 57.6 consensus. The details were broadly positive with most categories (except imports and new export orders) showing gains from April levels. Prices paid at 64.3 was also the highest since Sept 2017 while the order backlogs of 60.5 was the highest on record. Employment also jumped to 54.1 from a prior read of 53.6.
Finally, job openings in the U.S. unexpectedly rose to a new record in April, with vacancies increasingly exceeding the number of unemployed workers amid a robust labor market. The Job Openings and Labor Turnover Survey for the number of job openings increased by 65k to 6.698 million versus an estimate of 6.350 million and slightly ahead of a revised 6.633 million in March. The quits rate remained unchanged at 2.3% which is a cycle high level and in the range that prevailed pre-crisis. Thus, this report confirms the solid standing of the labor market and will keep the Fed in hiking mode next week.
European Economic Surprise Index Continues Lower
We mentioned the softening in the European economy and that can be seen visually in the graph. The Citigroup European Economic Surprise Index works just like the domestic version which measures whether a published economic release beats or misses analysts expectations. In Europe, this year has been characterized by a string of weaker-than-expected releases. What’s also unusual is the length of the current decline. Typically, analysts see a softening in results and adjust forward-looking estimates, but in this case the slowdown is intensifying beyond even the weaker estimates.
Agency Indications — FNMA / FHLMC Callable Rates