May Rates Update

Monthly Commentary

June 01, 2016

While May was largely devoid of market moving news, 2y yields finished 10bps higher for the month as the FOMC tried to breathe life back into a summer rate hike with hawkish rhetoric in both public statements and the April FOMC meeting minutes. This renewed hawkish tilt, at least from parts of the Fed, froze equities and commodities in their tracks indicating a lack of commitment from market participants to push market pricing in either direction before receiving more information. Additionally, this hawkish rhetoric reignited a rally in the trade weighted U.S. Dollar which pressed back higher after closing lower on a month over month basis for three consecutive months. In and of itself, a USD rally does not necessarily have to coincide with significantly tighter financial conditions, but Bloomberg’s measure of financial conditions did show some decay in financial conditions by the end of the month. This relationship between the dollar and financial conditions will continue to be worth monitoring as the deflationary aspects of dollar strength could further act to impede the Fed’s hiking ambitions.

After delivering a fairly unified, balanced policy message in the April FOMC statement, there was clear evidence of significant fissuring in FOMC thinking apparent in the April meeting minutes. The minutes showed that meeting participants, defined as nonvoters, “judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2% objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.” Conversely, FOMC members who vote on policy “generally agreed that, in light of the recent weak readings on spending and production, and with inflation below the Committee’s objective, it would be prudent to wait for additional information bearing on the medium-term outlook before deciding whether to raise the target range for the federal funds rate.” While voters are clearly a bigger driver of policy than nonvoters, this growing divergence between the two groups is noteworthy as Chair Yellen has not had her ability to build consensus tested during her time heading the FOMC. If her view of the world continues to warrant a more dovish bias than her fellow committee members would prescribe themselves, she will need to ensure Fed communication holds the line in the face of recent FOMC speaker headline grabbing.

Following the release of the minutes, market participants keyed in on the seven mentions of “June” and concern over the “unduly low” market implied rates. The market took this hawkish prod from the Fed and repriced the probability of a June policy tightening from 2% to 20% in the hours following the release. This explicit push back against market pricing was somewhat surprising considering the über dovish nature of Chair Yellen’s March FOMC press conference and subsequent speech at the NY economics club. However, this hawkish turn could be more a peace offering from the more dovish FOMC voters to the relatively more hawkish non-voters as Chair Yellen tries to build consensus moving into the second half of the year.

In an attempt to bridge the gap between Fed bank presidents, who are keen on tightening policy posthaste and Fed Governors, who generally prefer a more cautious approach, Chair Yellen weighed in on monetary policy at an end-of-month appearance at Harvard University. The Chair’s tone was characteristically even handed, balancing labor market strength against declining productivity growth and its spillover into GDP growth that has been “far too low”. Notwithstanding a few grievances against current economic data, Chair Yellen did caution market participants that they should prepare for a policy tightening “in the coming months.” While the idea of a rate hike in coming months may lead market participants to believe the June meeting is back on the table, the Chair’s wording and previous reaction function would argue against that idea. Given the opportunity to communicate her exact intentions to the market, the Chair didn’t mention the June meeting, which is only a single month away. Instead, she was presumably content to target the July meeting which would allow the FOMC to sidestep any event volatility related to the Brexit vote on June 23 and reassess any global economic developments before tightening policy. This idea that the Fed would sidestep a risk event and tighten policy only one month later is consistent with past Fed behavior which places a high premium on sureness of footing. By the close of the holiday shortened trading day, short rate expectations had repriced significantly higher to show a 31% chance of a June tightening or a 69% chance of a move in July.

In other central banking news, the Royal Bank of Australia (RBA) was the lone major central bank to take policy action this month, lowering its policy rate by 25bps to 1.75%. The main driver of the reduction of the policy rate was “unexpectedly low inflation data…[which] points to a lower outlook for inflation than previously forecasted.” Potentially most alarming for the RBA, Australian wage inflation currently sits at 2.1% annualized the lowest level since 1998. Unfortunately for the RBA this phenomenon isn’t just a function of pain in commodities related industries, wage growth in all sectors is currently below their long term average. Additionally wages for construction; professional, scientific and technical services; and administrative and support services have failed to grow in excess of 2% for five consecutive quarters. Despite 24 years of uninterrupted economic growth, recent economic data shows that Australia has joined the likes of the U.S. and the UK among others, who have failed to generate upward wage pressure despite a “tight” labor market.

Potentially part of the reason Australia has failed to generate the inflation they seek, neighbor China’s economic woes have served to throw a deflationary wet blanket over the commodities complex and commodities exporters generally. This deflationary theme continued to be prevalent this month as the PBoC fixed the USD/CHN spot price at the lowest level since August. It would be difficult to believe that this timing is purely coincidental as a FOMC rate hike once again looms. Moving forward, it appears that hawkish Fed rhetoric may be met with weaker Yuan fixings as China looks to distance itself from dollar strength. Evidence of deterioration in the Chinese economy comes this month from Moody’s who said, “China’s construction sector will remain lackluster with slowing revenue growth this year due to ongoing economic hardships.” Adding to this narrative, the cost of Chinese domestic steel, a bellwether for domestic demand, is down nearly 33% from its mid-April highs. Furthermore, borrowing costs for less credit worthy Chinese companies rated companies as proxied by the Chinabond BBB Corp 5y index pushed remarkably higher for the second month in a row to now exceed 15%. However, it is difficult to judge if this yield level is perfectly reflective of borrowing costs because of potential illiquidity in the Chinese corporate bond market. That being said, if this widening in Chinese corporate spreads reported by Chinabond is at all indicative of reality, Chinese corporations are now facing both higher funding costs and lower demand at the margin. Overall, none of these developments point to economic improvements, leaving market participants to wonder if a tail event from China is a possibility or an inevitability.

Now that Fed hiking expectations have been reset towards what they believe to be a more reasonable level, U.S. economic data will lead markets forward. As of late, overall U.S. data has been somewhat mixed but Q2 GDP has been encouraging, currently tracking a robust 2.9% according to the Atlanta Fed Nowcast Model. The largest contributors to GDP according to the model have been the strength of consumption, residential investment data and a less than expected drag from commodity related nonresidential structure investment. It remains to be seen if inputs to these GDP components can maintain a similar pace for the remainder of the quarter, but if they manage to do so the U.S. will be back within striking distance of 2% real growth for 1H 2016.

Source: Bloomberg

Australian Wage Price Index YoY

Source: Bloomberg

China Domestic Hot Rolled Steel Sheet Spot Average Price

Source: Bloomberg

Chinabond Corp BBB 5y Yield Index

Source: Bloomberg

Dollar Strength to Re-Tighten U.S. Financial Conditions?

Source: Bloomberg

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