With President Trump’s approval of tariffs on Chinese goods worth $50 billion (and the potential for another $100 billion), the markets are in risk-off mode. While the news wasn’t a huge surprise, the go-ahead given by the president has rekindled trade war concerns. In fact, China has quickly pledged to retaliate on U.S. exports of soybean and pork. That tit-for-tat has Treasuries rallying with the 10-year yield down to 2.91% after starting the week at 2.95%. The rally this morning is really a continuation of the ECB-inspired rally from yesterday that came after the central bank said that they wouldn’t consider rate hikes until the summer of 2019, at the earliest. Add in the Fed’s actions from Wednesday and the yield curve (2yr-10yr) has flattened to new cycle lows. The spread touched 35bps this morning, and with forecasted hikes by the Fed in September and December a flat to inverted curve could be in the offing by year-end. Given several Fed officials reluctance to invert the curve, rate hikes after December may face some resistance absent a back-up in the long-end, but with trade war rhetoric heating up again that back-up may be tough to accomplish.
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You may have thought that with the Fed’s rate hike on Wednesday, and expectations for an accelerating pace of rate hikes this year, that the market would still be digesting that move with Treasuries struggling. Well, that wasn’t the case yesterday as the ECB also had a meeting and in that gathering they struck a decidedly dovish tone. Market expectations were for the ECB to announce a future date for tapering of their QE program and while they did that they also announced no expectation of rate hikes until the summer of 2019, at the earliest. That declaration and some downgrading of expected GDP growth led to a rally in Treasuries that more than offset the limited selling that transpired after the FOMC meeting.
The euro currency and bond yields dropped after the ECB said it’ll phase out the QE program with 15 billion euro($17.7billion) of purchases in each of the final three months of the year which is down from the current 30 billion euro per month. They will, however, continue to reinvest maturities after December until such time that they believe some run-off will be appropriate. Thus, while the portfolio won’t grow after December it won’t be shrinking either.
What drove yields on euro-bonds and the currency lower was the downgrading of the GDP outlook this year from 2.4% in the previous forecast to 2.1% at this meeting, and the declaration that rates won’t be raised until summer 2019, at the earliest. Also contributing to currency weakness and bond yields dropping was ECB Chair Mario Draghi’s inability, in the eyes of the market, to reconcile the downshift in growth with a rising estimate of inflation. The latest forecast has euro-area inflation rising from 1.4% this year to 1.7%. The Italian Draghi also expressed concern over the new Italian government, and while the crisis level has decreased in the last couple weeks the populist bent of the new government is a major concern to EU institutions which obviously includes the ECB. That only added to the bearish growth outlook and aided the bond rally and currency weakness.
So despite the pledge to begin reducing the QE program later this year, global bond markets rallied on the softer growth forecast and decision to hold back on rate increases until next summer. That rally included Treasuries which more than reversed the selling from the Fed’s decision to hike rates yesterday and accelerate the pace of hikes this year. In fact, the 2yr-10yr spread fell to a new cycle low of 35bps, the flattest curve since August 2007.
If you needed a good example of the divergence between the U.S. economy and the rest of the world this was a good week to find those examples. While Europe was wrestling with a downgraded economic outlook from the ECB and a commitment to hikes rates until next summer, you also had the Bank of China refusing to raise rates after weaker-than-expected industrial production and retail sales. The Bank of Japan concluded two-day meetings this morning with no change in their low-rate regime and QE program (and downgraded inflation forecasts). Those dovish actions contrast with the moderately hawkish Fed and strong May Retail Sales which gives Fed hawks more ammunition to keep the rate increases coming.
Retail Sales for May were strong with the month-over-month increasing +0.8% versus +0.4% in April and easily beating the +0.4% anticipated. Sales ex the volatile auto segment were equally strong at 0.9% versus 0.4% in April and 0.5% expected. Even the control-group (a direct GDP input) outpaced expectations at +0.5% versus +0.4% consensus but was under the upwardly revised April gain of 0.6% (from +0.4%).
While the results will incrementally add to GDP estimates for the quarter, the report failed to dent the rally in Treasuries that was inspired by the aforementioned dovish tone of central banks outside the U.S. With real wages (adjusted for inflation) unchanged over the last year, the market is probably taking the tack that the April/May gains are not likely to be sustained in the second half of the year. The lack of a downside move in Treasuries in the face of the impressive sales figures implies the rally may have more room to run. It may also imply the divergence between U.S. and rest-of-world may limit the rate hiking ambitions of the Fed as emerging market economies strain under a strengthening dollar and that is likely to worsen off the divergent economic paths.
Treasury 2yr-10yr Spread Flattens Further
The Fed tightened rates on Wednesday flattening the Treasury curve further as they also accelerated expectations for rate hikes this year. But the real flattening move occurred yesterday after the ECB said it wouldn’t be thinking of hiking rates until the summer of 2019, at the earliest. While the ECB has been more dovish than the Fed for awhile, the directness in which they indicated their absence of rate hiking intentions led to a solid rally in longer-term Treasuries which has flattened the 2yr-10yr spread to 36bps, the lowest since August 2007. If the flattening continues, and we expect it will, it’s likely to inhibit the Fed’s expected rate hikes as the curve gets closer to inversion.