Why Is The Yield Curve Flattening?

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by: Alpha Gen Capital

Summary

The Federal Reserve continues to push up the benchmark rate with its fifth rate hike since December 2015.

Shorter-dated paper has seen a very rapid increase in the last two years given that the tightening started from the zero-bound.

Longer-dated rates have remained suppressed as inflation has underperformed in recent months.

Caution is warranted in the equity market given the lack of hard data follow-through since the election.

After months of ignoring the Fed and focusing solely on the new administration in Washington, the spotlight is back on Chair Yellen. The Fed continues to tighten monetary policy by inching up the benchmark rate. We now have a "1" in front of our fed funds rate for the first time in more than 8 years.

This is the 15th tightening cycle since the Second World War. In all but three of those cycles, a recession followed. During the typical recession the S&P 500 falls by nearly one-third. But the last two recessions produced much larger drawdowns of 49% and 57%, peak-to-trough.

In the 95th month of the current expansion, much of the pent-up demand has been exhausted. We are now fully into a new expansionary mode and are experiencing a very tight labor market. This is why the Fed is taking action by pushing up borrowing rates via the fed funds rate.

The 3-month Libor rate and 6-month yield have moved up alongside the fed funds and are starting to anticipate another hike:

Chart 3-Month LIBOR based on US Dollar data by YCharts

Conversely, interest rates on the long-end of the curve have declined since the start of the year. The 10-year yield fell to fresh 2017 lows last week of 2.11% while the 30 year hit 2.78%. The 10 year-3 month T-bill Treasury spread is close to eclipsing the tightest levels since early in the Financial Crisis, set in mid-2016.

Chart 10 Year-3 Month Treasury Spread data by YCharts

What is driving long-term interest rates lower?

Lower Inflation Expectations!

(Source: Bloomberg)

For the third month in a row, we had weak core CPI (consumer price index) results. This may end up restraining further action on rates by the Fed and force them to act on the balance sheet instead. We have been calling for weaker inflation readings in our monthly newsletters- although to be fair we thought it would be coupled with a stronger dollar. CPI is now at +1.9% yoy and given the lower PCE numbers, we expect to see that figure fall by at least one-tenth as well to +1.4%.

At its peak, yoy core CPI came in at +2.8% in February. Comparing to the year ago period we see that we are likely to witness further erosion in the yoy core CPI as we move through the summer.

Meanwhile, oil has cratered in recent days (surprising! [sarcasm]) as we learned that several members of OPEC have been cheating. We have been bearish on oil for all of 2017 and the price is down 17%. We continue to believe that we will eventually see a "3" in front of the price of West Texas Intermediate as US production continues to crank up.

Chart WTI Crude Oil Spot Price data by YCharts

With oil falling, high yield spreads very tight, the yield curve flattening, and the Fed tightening monetary policy, the room for error is becoming small. So while parts of the market are shrugging off the data, we remain vigilant and are seeking to improve the 'quality' of our portfolio.

Will The Yield Curve Invert?

Remember, the U.S. central bank is unique in that they have a dual mandate: full employment and stable prices. We are at full employment. In fact, Yellen commented that the rate is "a little below" full employment as the Fed reduced their forecasted unemployment rate for 2017-2019.

While stable prices doesn't imply a specific inflation target, the Fed has stated on many occasions that a 2% PCE figure is their objective. At 1.4%, the data point is well below that target.

So we have one of their mandates at or slightly ahead of their targets requiring "action" while the other half of their mandate remains stubbornly below their goals. The Fed officials with voting power are then forced to weigh both sides and determine which is the more pressing issue.

For most of the Fed officials, it would seem that playing defense on the employment side is swaying their decisions. The 'threat' from wage inflation at these levels of unemployment is real; but, looking at EPI's wage tracker, even that has rolled over.

With wages hitting a ceiling and largely tracking with CPI, the threat doesn't appear to be real at this point.

Our Take

We think that the Federal Reserve conveyed a hike for June and backed themselves into a corner which forced their own hand. Hard data is not accelerating; in fact it has been declining in recent months. Inflation is decelerating to the point where the Fed typically is in an easing phase. Meanwhile, soft data is starting to converge back to the level of hard data, a call we made back in December.

(Source: Bloomberg)

We think the chances of the Fed increasing rates again in December are low if the data continues to be in the same range in which it has been over the previous four months. The market is already discounting the chances with just a 38.1% chance of a December hike. This is the lowest level of probability that we have seen for a well-telegraphed hike by the Fed in this tightening cycle.

Still, even if the Fed acts again, it doesn't mean that the longer-maturity yields have to react. The copper-to-gold ratio, which correlates nicely with the 10-year Treasury rate, is trending slowly lower.

Most importantly, the cap on the change in Treasury rates on the long-end will be muted. The last three tightening cycles have seen little movement in the long-end of the curve. Below is a coup de grace chart:

Over the last three tightening cycles the average change in the 10-year yield has been just 96 bps. When the Fed initiated their first hike, the 10-year rose to 2.31%. The high it hit during this tightening cycle was 2.63%, or 32 bps above the initial rate. But we are down below that level today at 2.19%.

Conclusion

The bond market is being driven by the data, mainly inflation and softer hard data. Meanwhile, the equity markets continue to be fueled by optimism and sentiment, which is still high but waning in recent weeks. We remain cautious on the equity markets due to the Fed's tightening of the monetary supply and the lack of any traction to economic growth outside of employment.

There are a significant amount of real threats out there and with a VIX in the single digits, the market remains overly complacent. We think the Federal Reserve is tightening too rapidly, despite nearly 7 years of ultra-low interest rates.

The Fed and many analysts are using the same tools to measure economic performance as they did in prior expansions. But given the new normal, that playbook may be too aggressive and could cause volatility, and this warrants caution on the part of investors.

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