October Rates Update

Monthly Commentary

November 02, 2016

While September played host to a plethora of Central Bank meetings globally, October was less eventful as the market turned its attention to the U.S. election and the potential outcomes of the November FOMC meeting. Notably, despite this wait -and-see approach toward macro catalysts, 30y Treasury yields surged 30bps higher as the Treasury curve steepened 15bps between 2y notes and 30y bonds to a spread of 173bps. This push toward higher yields comes in part due to expectations of potential fiscal stimulus globally as central bankers have started to show reluctance to continue to backstop asset markets to the extent they have since 2008. That’s not to say the days of QE are completely behind us, but it seems central bankers have collectively lost their appetite to push the total number of rate cuts seen since 2008 much past the 666 cuts we have seen already.

The lack of appetite for further easing by a central bank was on display from the ECB this month as they moved towards deciding if further accommodation will be necessary when the current asset buying program expires in March 2017. Despite being given many opportunities to deliver clear forward guidance in his post-meeting press conference, ECB President Draghi dodged direct questions about the future of policy and left much to be desired in terms of clear market guidance. By failing to set a clear policy path at the October meeting, the ECB has allowed the market to begin to doubt its commitment to further easing. By permitting the market to doubt their resolve, intentionally or unintentionally, the ECB may be setting themselves up for unnecessary pain when it is finally time to make a policy decision. If the market has taught central bankers globally one lesson since 2008, it’s that asset markets don’t respond well to surprises.

Though the future path of global monetary policy is uncertain, in the past weeks central bankers have communicated a desire to move away from yield curve flattening policy toward policies that are conducive to steeper yield curves. In the past, yield curve flattening had been welcomed, as long end government rates were tied to lower borrowing costs for the consumer and the portfolio balance channel. Keeping long end rates low came at a price however, as banks in countries that have enacted QE and then negative rates saw their net interest margins (NIMs) compress. Additionally, there has been considerable push back from the pension and insurance sector as well as they struggle to meet liabilities in a low single digit interest rate world. This pain has gotten the attention of Central banks who are now working measures to alleviate NIMs pressure into their stimulus packages. Specifically, the BoJ, has begun to target the long end of the yield curve by reducing the amount of long dated Japanese bonds it purchases outright. The BoE included 100bln sterling worth of new funding to banks to help them pass on their most recent base rate cut. This was the first instance of a central bank making specific provisions to support NIMs within the context of a rate cut, suggesting an improvement in their understanding of the unintended consequences of QE.

To close out the month, market participants turned their attention to Q3 U.S. GDP data, which measured 2.9%, the fastest pace of quarterly growth since Q3 2015 GDP. Yet, the internal components of the report suggested that the economic reality was notably weaker than the headline number as the headline strength was driven by a 0.6% increase in inventories and a 0.8% contribution from trade. Historically, any upward or downward movement in net exports in U.S. GDP data tend to be reversed in the subsequent quarter, suggesting the staying power of this GDP report is suspect. Additionally, real final sales to domestic purchases rose by just 1.4% in Q3 versus 2.4% in Q2. Over the first three quarters of 2016 this indicator of domestic demand has grown at 1.7% on a YoY basis, which is nearly a full percentage point weaker than the growth rate of 2.6% in 2015. The majority of the drop in domestic demand in Q3 came as a result of slowing consumer spending, which only grew at a 2.1% pace, only half of the 4.3% figure seen last quarter. Also notable was the fall in capex spending, which has contracted in four straight quarters, which has never happened outside of a recession before.

It may be no surprise, however, that the consumer is wobbling given the continued push higher in medical and housing costs. On a CPI basis, Owners’ Equivalent Rent pushed 3.7% higher YoY in October, outstripping the most recent average hourly earnings report which only showed an increase of 2.4% YoY. If wages continue to grow at a slower rate than cost of living related goods and services then this mix of inflation could act as somewhat of a tax on consumers, pushing discretionary income levels lower. Judging by the downward trend in domestic demand seen in 2016, this “tax” may already be coming into effect.

While inflationary fears in the U.S. have gotten a significant amount of attention as of late, the specter of deflation out of China has faded despite USD/CNY fixing at five-year highs this month. In the last year or so, sharp CNY devaluation has sometimes had considerable repercussions for both equity and bond markets. In the last month, this impact seems to have diminished, as perhaps other overriding market influences appear to be at work. However, the fact remains that further weakness in the Chinese currency could eventually exert a significant bullish tailwind to the U.S. dollar, constricting any upward inflationary pressure in the US. This dynamic could ultimately wait until 2017 or beyond to reassert itself though, as the market appears to have deemed China’s economic situation as more sustainable than in the past as other Chinese risks assets have remained stable in the face of this continued devaluation.

Despite the lack of event-driven market catalysts, U.S. rates did see their largest selloff in over a year this month as market participants positioned themselves for the U.S. election, an imminent Fed tightening, and uncertainty abroad. It remains to be seen, if this bearish impetus can persist into the end of the year as long as market participants continue to need high quality yielding securities any moves higher in yield should see solid demand. It is possible however, that yields could climb the wall of worry as central banks allow market forces to reset risk free rates to higher levels as they hand off guardianship of their respective economies to their fiscal policy counterparts. In either case, November’s market events will go a long way in shaping the narrative moving into the end of the year ,as the U.S. political picture comes into focus along with the FOMC’s end-of-year intentions.

Source: Bloomberg

Consumer Prices

Source: TCW/Bloomberg

U.S. Treasury 5s30s Curve

Source: Bloomberg/Barclays

 10y U.S. Treasury Rate

 

Source: Bloomberg/Barclays

 

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW