The Fed Versus The Bond Market

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Includes: BAC, FAS, FAZ, IYF, KRE, XLF
by: Renaissance Research
Summary

The Fed expects a tightening labor market to trigger a rebound in U.S. inflation.

Moreover, the regulator is getting ready to reduce its $4.5trn balance sheet.

If the Fed is right, then Bank of America is a strong buy.

However, various market indicators tell a completely different story.

Mr. Market expects a lower-for-longer interest rate environment and, importantly, the recent sell-off in commodities and weak Chinese data will likely revive deflation fears.

The Fed

New York Fed President William Dudley recently reaffirmed that the central bank had taken a more hawkish stance. Mr. Dudley said that a tightening labor market and gradual wage growth should trigger a pick-up in U.S. inflation.

We are pretty close to full employment. Inflation is a little lower than what we would like, but we think that if the labor market continues to tighten, wages will gradually pick up and with that, inflation will gradually get back to 2 percent.

In addition, according to the so-called Fed's Dot Plot, we should expect one more rate hike this year.

Source: Fed

In other words, the Fed is saying that the U.S. economy is in pretty good shape, the reflation theme is still alive and we should expect more rate hikes. This view implies that interest-rate-sensitive names (XLF) (FAS) (FAZ) (IYF) (KRE) such as Bank of America (NYSE:BAC) are a strong buy here. As a reminder, according to the latest 10-Q, a 100-bps instantaneous parallel increase in interest rates adds $3.3bn to BAC's net interest income.

The Market

However, various market indicators tell a completely different story. First, it is worth noting that Mr. Dudley's comments did come as a surprise, given a slowdown in the so-called core CPI, which is a measure of inflation that excludes volatile food and energy components. The indicator has declined by 50bps since the beginning of the year.

Source: Bloomberg

Second, despite the Fed's hawkish rhetoric, the U.S. yield curve continues to flatten. The chart below plots the spread between the yields on 10-year Treasuries and 2-year Treasuries. The narrowing spread suggests that the bond market is showing a sign of caution over economic growth and inflation trends in the U.S.

Source: Bloomberg

Importantly, the so-called Breakeven Rates, which are a reliable indicator of the U.S. inflation expectations, have also been on a downward trend since the beginning of the year.

Source: Bloomberg

These indicators are telling us that, contrary to the Fed's projections, the bond market expects a lower-for-longer interest rate environment that would be painful for Bank of America and other interest-rate-sensitive names.

In addition, the recent sell-off in oil and weak Chinese data will likely revive deflation fears. As the chart below illustrates, China's PMI has declined significantly since the beginning of the year.

Source: Bloomberg

Who will be the winner?

The key question is whether the current situation is a repeat of the 2015 correction. As the chart below shows, there was a time lag between a decline in the 2-10y Treasury spread and a correction in BAC's share price. In other words, if the bond market maintains its expectations for a lower-for-longer interest rate environment and sluggish economic growth, then the 2-10y Treasury spread will likely fail to reverse its declining trend. That would be a material headwind for Bank of America and other interest-rate-sensitive names.

As a buy-side analyst and a deputy portfolio manager, I oversee a financials-focused fund and will be continuously providing research coverage on developments with global banks. If you would like to receive our articles, consider following us by clicking the "Follow" button beside our name at the top of the page. Thank you for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.