October 11, 2017

While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from Bob Whalen.

The benchmark U.S. Treasury 10 year Note has traded between 2.10% and 2.40% for the last 7 months. This is despite the fact that the Federal Reserve has increased its short-term lending rate 3 times since December 2016 and is likely to raise it again before the end of this year. Almost all signs point to higher rates across the yield curve, yet this still hasn’t happened.

Both here and abroad we are experiencing a period of accelerating economic growth. Most (but not all) of the recent economic data confirm the overall market consensus of stronger and sustained global activity. The Federal Reserve is not only raising short-term interest rates but is also unwinding its balance sheet of fixed-income securities accumulated during its massive and long-term policy of Quantitative Easing. (QE – central bank purchase of government bonds in order to lower interest rates and increase the money supply). Finally, although still restrained, inflationary pressures are starting to creep higher.

So why haven’t intermediate and longer term rates moved sharply higher? Overseas, interest rates are still low and many central banks are still in a policy easing mode. This affects U.S. rates as well. Other issues such as North Korea, the Catalan situation in Spain, uncertainty over the tenure of Secretary of State Tillerson and concerns over who will be the next Fed Chairman have all put some downward pressure on rates.

However, the level of intermediate and long-term rates is ultimately driven by the overall rate of inflation. Currently, there are structural forces at work such as globalization, technological advances and possibly even artificial intelligence that continue to exert downward pressure on the inflation rate. Shoppers can immediately compare prices on the internet looking for the best deal. Amazon is entering food retailing, the hotel sector has to deal with Airbnb, etc., etc. This leads to a limited ability to raise prices by corporations, and therefore, cautionary hiring by employers. This leads to higher job insecurity among workers, thereby reducing calls for higher salaries. If wages aren’t rising, it’s much harder for inflation to reach the Federal Reserve target of 2.0%.

In a nutshell, if inflation fails to accelerate, the outlook for interest rates and Federal Reserve policy will be more subdued than most analysts currently expect. However, from our perspective, we believe that an acceleration in wages is coming, although the timing is difficult to precisely determine. The labor markets are clearly getting tighter. In last Friday’s employment report, Average Hourly Earnings in August were revised up to 2.7% year over year and for September, accelerated to 2.9% y/y, while the Unemployment Rate declined to 4.2%. Over the next 3-6 months, we believe inflationary pressures will slowly build, and intermediate and long-term rates will move higher and establish a new trading range, with the 10 year Treasury Note trading between 2.5 and 3.0%. Our research efforts will closely monitor any changes in the inflation environment and its likely impact on Federal Reserve policy.

Robert Whalen, 610-260-2224

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