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10 Year Treasury Jumps on Strong Manufacturing Data

With the holiday weekend, we have a short and sweet newsletter to basically address the spike in long term rates on Thursday.

Thursday’s 10am Philly Fed came out much stronger than expected, causing rates to spike. The 10yr Treasury jumped 9 basis points following the release, closing the day at 2.72% after spending most of the week stuck at 2.63%.

I can’t ever recall a 9 basis point reaction from a Philly Fed print. Manufacturing is seen as an important indicator of the overall economy, but it’s as if the market completely forgot that Yellen had just said “I hope it’s completely clear that while monetary policy is very accommodating at this point”. I think the jump was larger than usual for two reasons:

1. Rates were already at the bottom end of the range (as written about in last week’s newsletter), so traders were looking for an excuse to sell and take profits off the table.

2. The holiday weekend translated into a less liquid market, so any movement would exaggerated.

Where do fixed rates go from here? Absent conclusive directions from eco data and Fed- speak, the natural tendency is for rates to gravitate toward the middle of the range. For the 10 year Treasury, that would be around 2.78% – 2.80%. I don’t think traders are going to hit the sell button when the get to their desks Monday morning after a weekend of worrying about how strong the Philly Fed print was, but I also think a bounce off the bottom of the range was expected, hence our recommendation last week to lock in hedges.

For those that weren’t able to execute before Thursday’s jump, the question becomes whether to lock now or wait to see if there’s another swing lower ahead. I think the analysis is largely the same as last week. We are still much closer to the bottom end of the range than to the top and the asymmetric risk/reward profile remains.

Short term asymmetric risk/reward – 0.10% decline versus a 0.25% increase

Long term asymmetric risk/reward – 0.35% decline versus a 1.25% increase

Inflation

Inflation data came in higher than expected this week, probably contributing a bit to the exaggerated rate movement on Thursday. Some of the increase is likely a rebound following a string of weak inflation readings, but the consensus is that inflation is beginning to normalize.

In the near term, Fed officials continue to see deflation as a greater threat than inflation. This suggests LIBOR will remain low for quite some time; however, the Fed forecast does reveal a move back towards the 2% inflation target. Yellen touched on two critical assumptions in the Fed’s inflation forecasts:

1. “As labor market slack diminishes, it will exert less of a drag on inflation”

2. “Inflation expectations will remain anchored near 2% and provide a natural pull to that level”

As we’ve pointed out repeatedly over the years, the Fed is notoriously bad at forecasting, so take all of this with a grain of salt. There’s plenty of slack in the labor market and we can’t assume a reduction of slack immediately translates into higher inflation. Additionally, the Fed could be overestimating the amount of downward pressure on inflation that labor market slack is exerting. In fact, she even noted “during the recovery, very high levels of slack have seemingly not generated strong downward pressure on inflation.”

Nearly every client we speak with is concerned about the impact QE Ad Nauseum will have on inflation, particularly how that flows through to long term Treasury yields. The Fed remains more concerned with deflation than inflation, but with CPI readings picking up, inflation may become a more frequent topic in the coming quarters. Just remember that markets will try to front run inflationary readings and this could push Treasury and swap rates higher before the readings really reflect inflationary pressure.

Two key indicators this week that could push rates one way or the other – durable goods and housing. Durable goods is likely to come in strong, rebounding from a weak reading last month. This would tie out nicely with the Philly Fed print last week. Housing, however, is more likely to disappoint. Investors have picked through the distressed inventory, so demand is being driven by real home buyers. There could be a weather related bounce in existing home sales, but the longer term trend is likely to weaken. But once again Fed policy helped the banks (read: cartel) turn a tidy profit during the refi boom that followed QE policies.

Have a great week!

Click to Open: THE PENSFORD LETTER PDF

The Pensford Letter – 4.21.14