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.
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.