November Rates Update

Monthly Commentary

December 01, 2016

November of 2016 has already cemented its place in the history books with both a Chicago Cubs World Series win and the election of Donald Trump to the office of President of the United States. It was only the latter, however, that catalyzed a sharp selloff in U.S. Treasuries pushing 30y yields nearly 50 bps higher as inflation and growth expectations recovered in anticipation of the expansionary fiscal policy President-elect Trump is expected to enact. This “Trump Tantrum” in bond yields is not without precedent and now joins three other events including: the Fed’s 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013 and the European Central Bank’s (ECB) announcement of its own QE program in 2015 as a catalyst of a move of this magnitude.

The Trump electoral surprise was indeed a game changer. With a Republican sweep of the Presidency, House and Senate, the last six years of political gridlock may be coming to an end. This sweep was a rare occurrence as there have been only 18 years since 1965 that a single party controlled the presidency as well as both houses of Congress. The upshot of this clean sweep has seen the market shift expectations away from a continuation of the status quo and towards expectations of deregulation, tax cuts, corporate tax reform and fiscal stimulus. While the exact degree to which these policies may be enacted is unclear, the market took the notion of a Trump Presidency quite well as the S&P 500 rallied back toward all-time highs, the U.S. dollar index reached its strongest levels in 13 years and U.S. 30y rates pushed above 3%.

Although the market has moved from expecting recessionary conditions to U.S. economic prosperity almost overnight, it remains to be seen if this regime change will be a sufficient catalyst to generate the kind of growth and inflation currently being priced into the market. To illustrate the repricing in growth and inflation expectations, we can break down the sell-off in 10y nominals between 10 year real yields re-pricing 38 bps higher and TIPs break-evens moving roughly 25 bps wider which would suggest that roughly 60% of the sell-off is a result real growth expectations and 40% is a result of higher inflation expectations. However, the move higher in yields, which has helped pull the U.S. dollar higher in concert, may ultimately prove to be self-defeating from an inflation-expectation standpoint. If the dollar continues to strengthen at the pace seen since the Presidential election, it could serve as a deflationary headwind. Given that recent research cited by FOMC members suggests that a 10% increase in the value of the trade weighted U.S. dollar is roughly equivalent to 1% worth of policy tightening, the 5% appreciation in the dollar this month could represent two 25 bps hikes even before the FOMC gets the opportunity to move the policy rate in December. At the margin, it is reasonable to expect President-elect Trump’s economic framework to be supportive of growth and inflation but, it remains to be seen whether or not the days of 1.5%-2% real GDP growth and below 2% target inflation metrics are behind us.

While the movement in Treasury rates was impressive this month, it may have been more impressive that it took one night to push Eurodollar future implied FOMC hiking expectations towards levels that the FOMC has been trying to convince the market of for years. To that end, the implied probability of a tightening in December 2016 surged to reach 100% and 2017 and 2018 expectations recovered toward a pace of nearly two tightenings annually. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, this is still an FOMC that has only tightened policy once since announcing the start of a hiking cycle so expectations of such relatively rapid hiking may be premature. In fact, with inflation still below target and market-based measures of inflation compensation still depressed, the Fed may not be in a rush to signal a more hawkish policy stance. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed’s inflation target or when Chair Janet Yellen’s term ends in 2018.

Despite the fact the majority of price action in macro assets this month was driven by perceptions of the impact of the election. OPEC did manage to get market participants to pivot their attention briefly to their end of month meeting in Vienna. The conclusion of the meeting finally brought an end to OPEC crying wolf and saw an agreement to cut production for the first time in eight years. As part of the agreement, OPEC countries will cut production by 1.2 million barrels a day for an output of 32.5 million barrels a day starting January 1. Non OPEC countries will take down their production by 0.6 million barrels a day with a 0.3 million barrel a day cut from Russia. From here, the next step in the process is to see these cuts showing up as inventory drawdowns globally in the coming months. There is already some evidence of this taking place in the International Energy Agency data, led by falling non-OPEC output and continuing growth in global oil demand. Going forward, we will need to see the drawdowns accelerate with the OPEC/Russia cuts showing up.

The month of November may eventually be seen as a crossing of the Rubicon in the rates market as fears of deflation and recession have been replaced with a more optimistic view on inflation and growth, at least for the moment. This change in prevailing market sentiment saw the worst month of performance by the Barclays/Bloomberg Aggregate Index since July 2003. However, the impact of the election of Donald Trump still remains largely unknown and this month’s blind optimism could fade if it becomes clear he may not be able to deliver all the market hoped for. In the meantime, the market will look towards a December where a 25 bps rate hike from the FOMC seems to be a forgone conclusion to complete what has been quite an interesting 2016.


Source: Bloomberg

30y Treasury Benchmark Yield

Source: Barclays Live



Source: Barclays Live

10y TIPs Benchmark Yield


Source: Barclays Live


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