How long can the benchmark 10-year yield stay this low?
Outlook: Virtually no one raises the flag of “two negative quarters = recession”. A good excuse – excluding inventories, GDP rose 1.1%. As long as today’s personal income and spending are within recent ranges, we can continue to deny recession for some time to come. We could have a very negative surprise, like revenue up about 0.5% as expected, but much higher spending, again leading to insights of 75 basis points at the September meeting.
The key number that everyone will be looking at is core PCE, and we’re already seeing some shenanigans – annualized monthlys, annualized quarterlys. To set the record straight: on a q/q basis, Q1 delivered a core PCE of 4.4%. Here is a nice summary from Trading Economics:
If we are looking for a Fed funds that exceeds the base PCE, what number do we choose? A good candidate is the “Core PCE Price Index Annual Change” at 4.7%. We don’t know what today will bring, but regardless, it will be higher than the Fed’s own projection for fed funds at the end of the year – 3.5% (and the market is already reducing that as well). Even if this particular data point drops to (say) 3.5% by the end of the year, the Fed will still be behind the curve. Over a long period, the real return tends to be around 1.5-1.75%, which means that if the base PCE is running at 3.5%, the fed funds should be around 5, 20%. A real return of zero isn’t entirely worthless – Europe has been with it for some time – but it signals an anomaly and disarray in the fixed income market. The effective yield of the BoA High Yield index is 7.89%. Why buy so-called risk-free sovereigns if you can get a real return, but with higher risk? Even China offers a little more than the United States (2.759%).
This begs the question of how long the benchmark 10-year yield can stay this low – below 3% and even 2.75%.
The answer to that is, apparently, the answer to the question of how long the dollar can continue to fall against the yen. If we understand the reasoning, the reversal was caused by traders moving in a herd on the view that the US will prioritize growth over inflation control and not bring the 10yr down to 3% and above for some time. Even if we don’t doubt the Fed like the Japanese do, that could be correct. Traders are watching the most sensitive 2-year bonds and almost all countries are posting yield gains and are in line with the upcoming expected central bank hikes. The United States is expecting increases, but the 2-year is still falling. View the one-month chart. This morning, we have 2.892% against 3.246% only on July 17.
This series of developments is perverse. It’s the triumph of theory/wishful thinking/expectation over data and logic. But the market is never really wrong. It seems the only time it features in the standard monetary policy lag (12-18 months) is by applying it to inflation first, which means bondholders are seeing an inflation spike now for July or soon for August and September, after which the Fed will project less need for hikes. Why bother pushing the yield to (say) 3.5% when it will only come back down in a few months? This is a reckless disregard for the power of inflation.
Finally, in addition to consumer confidence (which we don’t need when we have spending and retail sales), we obtain the employment cost index. This is a third tier data point that hardly anyone notices for the simple reason that it’s so hard to measure and is sure to be wrong (plus companies cheat) . Year-on-year is expected to be a humdinger, leading to the idea that the price of production must also increase (sorry, Jay). Trading Economics agrees with the 1.2% consensus.
The dollar is down (and commodities, gold and commodity-related currencies are up) as the bond market expects a dovish Fed, if not after a few more bulls. That’s a bad thing, and not just because it embodies a lack of confidence in the Fed’s resolve. “Let it heat up for a while” still rings in their ears. What if the bond market was right? The dollar rout may be longer than we currently expect. Wait for developments.
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