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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