By the third-quarter of 2017 the experts opined, the 10-year UST note should have been approaching 3.00%, inflation was supposed to be running hot due to Trump fiscal policies and a behind-the-curve Fed. Instead, what we got was discord among Republicans, U.S. economic growth stuck at an annualized rate of about 2.0% and inflation which remains stubbornly low. Instead of soaring higher, the 10-year UST note yield hit its lows for the year, closing at 2.04%, in early September. Although the 10-year UST note yield stood at about 2.30% at the time of this writing, it is still a long way from where Wall Street group-think thought it would be by now.
Why inflation remains so well-contained has been the subject of much debate during the past three months, with much disagreement among economists as to why inflation remains stubbornly low. Earlier in the quarter, Fed Chair Yellen opined that inflation was low because of a price war going on in the mobile phone industry, but by the end of the third quarter, it was clear there was more to it than that. Year-over-year oil price comps also helped to hold down inflation. When we dig into the August (most recent) CPI data, we see services inflation ran an annual rate of 2.5%, but apparel prices declined -0.6%. Automobile prices were down 0.7% and medical care price inflation was a tame 1.1%. There is something more going on here than cellphones and crude oil.
In my opinion, it is all about technological efficiencies:
We have become so much more efficient on the downstream/delivery side. Technology had lowered the cost of delivering/offering goods and services to consumers. This increase in productivity is not captured by traditional productivity measures, as they are focused on the upstream/production side of the economy.
Technology, including Amazon, has increased the competition for consumers’ dollars. This lack of pricing power helps to hold down inflation. Technology has also helped to contain energy 2 prices. Oil and gas exploration and extraction is less costly than in the past and allows smaller players to profit. Thus, inflation pressures are structurally softer. This is not rocket science, but there lies the rub.
Economics, nay the entire financial industry, has been transformed into a world of models and algorithms created by rocket scientists, physicists and mathematicians. These models are based on mean reversion and repeating history. Meanwhile, the economy has changed in front of their eyes and continues to do so, but few wish to look away from their well-established models. Economists are reluctant to do so because no one wants to be wrong. Those who will be most successful forecasting future economic conditions and investing will be those who are focused on what is happening rather than what should be happening. Give me a sharp trader, strategist or historian over an economist or quant any day of the week.
You would think after more than two decades of tame inflation and nearly four decades of falling interest rates/bond yields that economists and economic theorists would figure out that something about the economy is structurally different than the economy which persisted when their well-established models were created. Sadly, they haven’t. According to the most recent Bloomberg Survey, economists see the 10-year UST note yield at 2.42% at the end of 2017 and 2.96% at the end of 2018. I concur with the consensus opinion that the 10-year UST note could be at or near 2.42% at the end of 2017. However 2.96% at the end of 2018 seems a stretch, for me. For this to happen, inflation pressures would have to build and the Fed would have to let them. However, recent comments by Fed Chair Yellen say otherwise.
Ms. Yellen stated that it is prudent to tighten monetary policy, even with the Fed’s favored inflation measure well below their 2.0% target. The Fed Chair appears to be conceding that inflation might be structurally lower than it was in the past and that normal monetary policy (whatever that means this time around) has to me normalized sooner rather than later. What might “normal” monetary policy look like? According to the Fed’s latest “Dot Plot,” the Fed Funds Rate is expected to crest at 2.875% by the end of 2020, before retreating to 2.75% by the end of 2021.
This assumes that the economy does not experience a slowdown or recession before 2020. Although that scenario could play out, most economists believe the U.S. economy could experience a recession before the end of 2020. That would/could cause the Fed to pause/halt monetary policy tightening before the Fed Funds Rate reached 2.875%. Remember, Fed Funds Rate hikes are intended to be disinflationary. Thus, higher Fed Funds Rates could put the brakes on rising long-term rates or even send them back down. This is why the yield curve tends to flatten when the Fed is in tightening mode.
What about balance sheet reduction? Couldn’t that push long interest rates higher as the bond market gradually loses a large buyer of U.S. Treasuries? There are two problems with this theory. For one, the Fed does not own much and has not been buying many bonds on the 10-year area of the yield curve. Thus, there should not be much upward pressure on 10-year, or even 30-year UST yields from Fed balance sheet renormalization. The greatest upward pressure from balance sheet renormalization should come where the Fed was buying most actively, the 5-7-year area of the curve. This should be followed by rising short-term rates from traditional Fed Funds Rate hikes. The result should be a flatter yield curve.
We must also understand that balance sheet reduction is, at least in theory, quantitative tightening. Thus, it could be considered anti-inflationary. The result could be that UST yields on the 10-30-year portion of the yield curve not rise all that much. Thus, Fed tightening, traditional or quantitative, should augur for a gradually flattening yield curve. I haven’t even mentioned the demographic and actuarial demand for fixed income, which should also help to contain long-dated bond yields.
A threat to my forecast of contained long-term rates is tax reform or, more specifically, unfunded tax cuts. This could light a fire under long-term rates by threatening stronger inflation inputs. However, threats of stronger inflation pressure would likely elicit a commensurate response by the Fed. I.E. The Fed would likely become more hawkish. However, this is a discussion for 2018 and not Q4 2017. Wage driven inflation could materialize, but I am not a believer in the Phillips Curve.
Markets will be paying close attention to GDP prints. U.S. GDP printed at an annualized 1.2% in the first-quarter of the year. GDP rebounded in Q2 to 3.1%.Thus, 2017 first-half GDP averaged an annualized 2.15%. As of the time of this writing, the Atlanta Fed’s GDPNow estimate for Q3 GDP stood at 2.1% (the New York Fed’s Nowcast Q3 estimate stands at 1.6% and its Q4 estimate stands at 2.0%). In recent years, Q3 has tended to be stronger in Q3 than Q4, but hurricanes will probably weigh down Q3 GDP, but rebuilding efforts could boost Q4 GDP. I would not be surprised if we saw a 1.8% Q3 GDP print and a Q4 GDP print around 2.5%. If my base case scenario plays out, GDP for 2017 would average around 2.15%, the same as the 2017 first-half average.
I would caution readers against assuming that strong, or even just positive, GDP, will equate to stronger inflation pressures. Although growth and GDP can be positively correlated, they can become disconnected. In the late 1970s, the U.S. economy experienced high inflation and economic stagnation and contraction. In the 1920s, the opposite was true. The 1920s was a period of technological innovation in manufacturing. The result was more goods available to consumers at lower prices. In today’s digital economy, electronic innovation has created a similar solid growth/low inflation scenario. As I was going to press, the August reading of inflation, as measured by Annual Personal Consumption Expenditures, printed at 1.4%, unchanged from July and below the Street consensus of 1.5%. Core PCE YoY, the Fed’s favored measure of inflation and to what it refers to when it speaks of a 2.0% inflation target, printed at 1.3% for August. This was down from a prior 1.4% and below the Street consensus estimate of 1.4%. We should see somewhat hotter headline inflation in September, mainly from fuel prices, but inflation should settle down from there as year-over-year oil and gasoline price comps narrow.
In my view, the long end of the yield curve will be most sensitive to inflation expectations and reflationary fiscal policy proposals. Recently, we have seen long rates surge higher on hopes of tax cuts and potential progress on fiscal policy reforms. I.E. the reflation trade. Although I do think tax cuts are implemented, I believe they will end up being far less impactful than what is currently proposed. In my opinion, tax cuts, whatever form they take, are a 2018 story.
About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.