Bond Market Week In Review For The Week Of October 8-12

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by: Hale Stewart

Summary

The President is trying to jawbone the Fed. This shouldn't be happening.

Despite all the hubbub over the market, the yield curve is still pretty narrow.

According to the Fed's "dot plot," it's still possible that the Fed could tighten into an inverted yield curve by the end of next year.

It's been a bit since I wrote this article, largely due to scheduling constraints. But there's been a great deal of meaningful bond market news over the last few weeks (and this week especially), so it seems appropriate to write this column this week.

Let's start with this point: regardless of your political affiliation, I think we can all agree that the president should shut the hell up when it comes to the Fed. That's not what we have right now:

President Trump responded to falling stock prices on Thursday by continuing to throw rocks at the Federal Reserve, which he has described as "crazy," "loco," "going wild" and "out of control" for slowly raising interest rates against the backdrop of a booming economy.

A truly independent central bank is a must for the economy. The above comments are not needed. Period.

The bond market was the red-headed stepchild this week, as writers and analysts partially attributed a spike in 10-year yields to the stock market sell-off. Was this really a big deal from the bond market's perspective? I would argue that the answer is "sort-of." Let's go to the charts:

Let's parse this information slowly. The blue line is the 30-year Treasury yield while the red-line is the 10-year yield. Both have a left-hand scale. The green line shows the spread between the 10- and 30-year; it has a right-hand scale. Yes, there was a sell-off to the tune of about 20-25 basis points. But as the green line shows, the spread between the two main long bonds really didn't change that much. In other words, long-term yields rose, but the relationship between the two - which was already very tight - wasn't fundamentally altered.

Next, let's look at the spread of the belly of the curve:

Since July, the number has been fluctuating around 100 basis points. More recently, the spread widened at the end of August/beginning of September to about 115 basis points. It tightened when the Fed raised rates at its last meeting. The latest sell-off again widened it a bit. But overall, the spread is still fluctuating around 100 basis points.

The actual yield curve helps to put this all in perspective:

The shape of the yield curve is still the same: it is still narrow. What really happened is that yields are slightly higher across the board.

As for where the bond market is headed, remember that inflation expectations are a large component of the term structure of interest rates. And those are very much contained:

This is why I haven't been overly concerned with the sell-off in the long-end of the curve. Investors aren't concerned about inflation, which means there's a ceiling on interest rates.

Next, the BLS released the latest CPI this week:

Overall CPI was 2.3% while core was 2.2%. Something to remember is the Fed's 2% price target is not a ceiling; it's symmetrical: prices can be below or above 2%. Right now, CPI is running slightly above 2%:

But this is not the Fed's preferred inflation measure. It believes (I think correctly) that CPI is too narrow a measure of prices. It prefers the PCE price index, which is just over 2% right now:

The combined reading of both measures is that prices are right above 2%. Given that we were talking about weak price pressures for a number of years, a bit of time about 2% for both CPI and the PCE price index won't be fatal. In fact, we could argue it's healthy.

Finally, let's turn to the Fed's "dot plot" to get an idea for where rates are headed:

Right now, the Fed Funds rate is 2-2.25%. The plot says we're going 25 basis points higher by the end of the year. After that, the picture is murkier; we could see rate increases of 50-100 basis points next year. Let's assume the Fed goes all out with four hikes and that the 10-year stays about where it is. By the end of next year, we'd see an inverted yield curve.

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.