For months, market pundits have asked: “What is the bond market trying to tell us?” Much of the punditry could only see calm seas and blue skies ahead. The bond market has been trying to tell investors what I have been trying to tell investors:
Although the deflationary scare is over, inflation/reflation expectations are probably equally ill-conceived, or at least overdone.
After last week’s disappointing economic data, the Atlanta Fed lowered its Q1 2017 U.S. GDP forecast to 0.5%. The Atlanta Fed’s Blue Chip consensus reading from outside economists places Q1 GDP around the 1.4% area. The Bloomberg Survey of Economists indicates a consensus forecast of 1.5% GDP for Q1 17 and a 2.7% forecast for Q2 17.
It has been noted that, during the current period of economic expansion, first-quarter readings of GDP have been weak, but growth has rebounded in Q2. However, the two-quarter average has tended to be around the 2.0% area, consistent with annual readings, since the last recession. As such, while we should probably not become too alarmed over a weak Q1 17 GDP print, we should not become giddy over a potentially stronger Q2 17 GDP print. Given that population growth appears likely to repeat around the 1.3% area and 2017 is shaping up as another year of 0.7% productivity growth, this looks like another year of 2.0%-area U.S. GDP. With a lite version of tax and regulatory reform, mid-2.00% economic growth is possible. That is probably all she wrote, for 2017. If we see productivity around the 0.7% area, wage growth may not be anything to write home about, this year.
Although not the end all and be all of economic indicators, the April reading of the New York Fed’s Empire Manufacturing Index printed at 5.2. This was down prom a prior 16.4 and below the Street consensus estimate of 15.0. Prints above 0.0 indicate expansion.
Yes, Empire Manufacturing was positive, but the drastic slowing of expansion would appear to indicate that the post-election bump is over. It might also indicate the expected (hoped for) Q2 rebound could underwhelm. Many of the components were expansionary. The Current Number of Employees index advanced to 13.9 from 8.8 in March. Shipments increased to 13.7 from 11.3 prior. However, the work week index slipped to 8.8 from 15.0 and new orders slowed significantly, falling to 7.0 from 21.3, in March. New Orders data tend to be forward looking and correlated to inventory building, which tends to influence GDP calculations. Instead of providing signs of an economic rebound, Empire Manufacturing data allude to a continuation of mediocre economic growth.
Dog Day Bond Market?
The recent rally in long-dated U.S. Treasuries has emboldened the bond bulls to begin snorting. Doubleline’s Jeff Gundlach predicted the 10-year UST note yield would fall to current levels. BlackRock’s Scott Minerd believes that the 10-year UST note could fall to 2.00% or even 1.50%, by the summer, as the result of a flight to safety. Mr. Minerd said in a note to clients that long-term rates could decline due to “disappointment around Washington delivering pro-growth policies and increasing risks abroad.”
I don’t disagree that the phenomena to which Mr. Minerd refers could/should help to hold down or limit the rise of long-term rates, but to get the 10-year UST note yield down to 2.00% or below, would likely take a fairly major shooting war involving the U.S., a French election result which augurs for a Frexit, etc. Without these occurrences, I believe that it is more likely that the 10-year UST note to be range-bound between 2.20% and 2.70%.
What about the shrinking of the Fed’s balance sheet? Remember, when the Fed ended new asset purchases, more than two years ago, the duration of its balance sheet has since declined. Based on the latest Fed data, the average maturity if its balance sheet is about six years. Assuming that the Fed shrinks its balance sheet mainly by letting assets mature, there may not be much upward pressure on the long end of the UST curve, from Fed balance sheet reduction. For long-term UST yields to truly breakout to the upside (10-year note approaching 3.00% or higher), we will need inflation to surge, from here, with some help from geopolitics. In my opinion, we may have already seen the strongest U.S. inflation readings for the year.