Has An Inflection Point Been Reached For Investors?

Interest rates, led by the US, have accelerated to the upside. With price pressures generally rising and oil prices at four-year highs, it is understandable. Market participants need to see that the breakout that has lifted US 10-year yields to their highest level in seven years is confirmed in subsequent price action. 

The first test was passed as the disappointing jobs growth in September could have been an excuse to push yields lower. Perhaps, it was not a completely fair test as the unemployment rate fell to the lowest level in nearly half a century and there were strong upward revisions.The next test may be next week’s inflation reports. The core rates of both the PPI and CPI are expected to have crept higher while the headline rate is either stable (PPI) or actually softens (CPI).

At the same time, despite some accusations of equivocating, we think Fed Chair Powell has been clear. Monetary policy remains accommodative with the Fed funds targets range below the neutral or long-term estimate. Interest rates will continue to be gradually lifted, and it may rise through the neutral rate. There is no reason to change the course until the economic performance changes in material ways. High-frequency data is noisy, and the Fed focuses on the signal.

At least four considerations are pushing US rates higher. First, the market is coming around to accept the Fed’s signal that three rate hikes will likely be appropriate next year. Since September 27, the implied yield of the December 2019 Fed funds futures has risen 12 bp to 2.93% (the average effective Fed funds rate is now at 2.18%). This suggests that 75 bp of tightening has been largely discounted. The second consideration is also due to the central bank. Fed officials have played down what had been a conceptual anchor of monetary policy, r*, the neutral rate. It is not clear what will replace it except the good judgment of same said officials. This is another form of ad hocery, for which investors may require an additional premium.

Third, the rise in oil prices lifts headline inflation, and there is a presently a strong correlation between oil prices and 10-year US yields. The US 10-year breakeven has about ten basis points over the past month, suggesting higher inflation expectations. This appears to account for about a quarter of the 40 bp increase in the yield of the 10-year benchmark note. Another consideration is the supply and demand dynamics. The supply is increasing, but the Fed is buying less, and the bid from corporate pensions ahead of the September 15 deadline has evaporated. The Treasury will raise $770 billion in H2 18, which is a 60% increase from H2 17. The cross-currency swap basis and the relative flatness of the US curve make it expensive to hedge the currency, which discourages another set of potential buyers.

The move toward 3.25% on the 10-year yield has stretched conditions, and near-term consolidation ought not be surprising. However, investors should be prepared for higher interest rates. The 10-year average yield over the past decade was surpassed eight months ago. The average over the past 20 years is 3.60%. Many are targeting 3.50% on the way to 4.0%.