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Volatility Returning To Interest Rates

Spent the weekend moving, so this is going to be short and sweet. Quite an interesting week we just had, huh? Wednesday opened with a 4% print on GDP, sending rates up by 10-15bps across the curve. The 10yr Treasury ran up to 2.57% and then paused to await the Fed decision.

The Fed’s rate announcement on Wednesday was slightly more hawkish than expected, pushing yields up another 0.03%, with the front end of the curve experiencing the most movement. As expected, Philly Fed President Charles Plosser dissented, saying the Fed shouldn’t provide forward guidance dependent on time (“considerable period of time”) but rather provide guidance that is data-dependent. There were some rumblings that Dallas Fed President Fisher may dissent, but he did not. He has been making more references lately to the Fed falling behind the curve and may be setting the stage for a dissent at one of the upcoming meetings. And during an interview Friday morning he did indicate that the hawks are gaining traction behind Fed walls. A hike is coming, and the first rate movement in over six years will be a big deal.

Friday’s job reports came out reasonably strong, but the fickle market swooned. The economy added 209k jobs last month, the six straight month with 200k plus jobs – a first since 1997. The last two months were also revised higher.

Although 209k was less than expectations of 230k, this is still a good print. July is a seasonally volatile number anyway. A 200k/month average translates into 2.5mm per year and a 1% decline in the unemployment rate. This just reinforces the notion that the UR could easily be approaching 5.5% by spring 2015.

Speaking of which, the UR actually ticked up to 6.2%, but only because the labor force participation moved higher. Although we are still below March’s participation level, this is a good sign that discouraged workers are optimistic enough to look for jobs again.

Lastly, this type of print implies GDP trend comfortably north of 2%. This is a good data release, and yet rates fell across the curve as if we were heading for another recession. We suspect much of Friday’s movement was short-covering. So many traders had positioned themselves short ahead of the job report expecting a gangbuster number that the modest print forced them to cover their positions. Monday morning should be a good indicator of what the market actually thinks about US yields.

While US fundamentals suggest rising rates, there are quite a bit of global concerns keeping a lid on rates.

  • Argentina defaulted (again) and it could get messi…see what I did there?
  • Portugal’s financial system is being stressed with Banco Espirito on the verge of bankruptcy (there may be an EU bailout Sunday night/Monday morning by the time we come into the office)
  • the eurozone economy continues to lag.
    • interesting article in Friday’s WSJ about Japanese investors seeing a lot of similarities between the EZ and the Japanese lost decades. With 10yr JBG’s yielding at 0.50%, EZ bonds look quite attractive if you believe low inflation will keep EZ rates anchored near zero for the long term. From a US standpoint, it seems absurd that yields for Italy and Spain are on top of our yields. But if the ECB is going to explicitly back all EZ sovereign debt AND you think yields could head to 0.50% just as they did in your own country, maybe 2.50% isn’t so bad.
    • Japanese investors have bought the most Italian bonds since 2005 and the most Spanish bonds since 2011.
    • ECB meets Thursday. Very low inflation plus sanctions on Russia do not a strong economy make
  • Russia. What are you going to do Comrade Putin?
  • Gaza

In general, I would say that domestic factors are more important than the global factors listed above for determining the direction of US rates going forward. The bias is towards higher rates, but those global issues are keeping a lid on rates for the time being.

Much quieter week ahead, with very little data and no Treasury auctions. We’ll be watching Fed-speak for any clarification on the FOMC meeting and then Saturday I get married (presumably), so no newsletter next week. Have a great week!

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The Pensford Letter – 8.4.14