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Making Sense: Fiscal Policy Failure And Structural Inflation

United States Municipal Bond

The idea that a softening of U.S. inflation pressures is far more structural than cyclical is gaining traction. Last week, Fed Chair Yellen cryptically acknowledged that this was possible. The recent soft inflation readings has diminished the ability of rising 10-year German Bund yields to push 10-year UST yields higher. In fact, the spread between the yield of the 10-year UST note and the 10-year DBR now stands at 171 basis points, the narrowest since September 2016.

Here’s the euro story

I have stated recently (on several occasions) that a stronger euro currency could prove problematic for the EMU growth and inflation recovery story. As such, it might be that the ECB and/or its banks are in the market purchasing USTs by converting euros to U.S. dollars. This could push down long-dated UST yields and limit how far the USD can rise versus the EUR. Until today, the USD had difficulty pushing through 1.15 versus the EUR.

I do not believe that the ECB will take the strengthening of the EUR lying down. Overnight, Bloomberg News reported:

“European stocks dropped the most in July as investors bet a stronger currency will drag on exporters’ earnings, while miners snapped a six-day winning streak.”

This supports my theory that the ECB cannot simply allow the value of the euro to soar. At present, I would seek to hedge international exposure by going long the USD, where appropriate.

United States Municipal Bond

Meanwhile, fiscal policy failures, the latest and most significant being the failure to repeal and replace the Affordable Care Act, is also helping to push down long-dated UST yields. Most pundits believe that it is the bond market’s way of pricing in slower economic growth due to the reduced likelihood that we will see meaningful healthcare and tax reform.

Where’s the fiscal policy?

I do not believe that proposed fiscal policies would have added that much to economic growth. However, adding fiscal stimulus to an economy which is already overstimulated and in late cycle is more likely to result in stronger inflation than stronger growth. Thus, the long end of the UST curve is pricing in a lower inflation picture. As I have stated in the past; the long end of the yield curve always and forever prices to inflation expectations.

Two weeks ago, I opined that, with the 10-year UST note yield approaching 2.40%, I took long positions of the 10-year UST note in portfolios for whom doing so was in their best interests. As the 10-year note yield has broken below 2.30%, I have exited these speculative positions. Now is the time to watch and wait.

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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.
Twitter: @Bond_Squad
E-mail: Thomas.byrne@wsandm.com

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Thomas Byrne

Thomas Byrne serves ad the Director of Fixed Income for Wealth Strategies Management LLC. Thomas brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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