Running in (a Good) Place?

Rates Update

December 12, 2019

A month after the Fed signaled a pause with respect to monetary policy, a decidedly positive tone around U.S./China trade talks intersected with a string of mostly firm economic data. For the time being these themes reaffirmed the Fed’s stance that the economy was still in a “good place” and that monetary policy will indeed be on hold as the Fed assesses the lagged impact of this year’s cuts to the Federal Funds rate. Although the direction of U.S./China trade talks and ensuing market reaction change on an almost daily basis, the positive turn in trade negotiations and mostly positive economic data releases in November signaled a green light for risk assets. On the month, the S&P 500 returned an impressive +3.63%, 30yr TIP break-evens widened +8 basis points (bps), IG credit produced +63bps of excess return and the belly of the Treasury curve sold off +10bps.

Geopolitics again took center stage and was the talk of the town across markets. The on-going trade tensions between the U.S. and China took a pause when both countries signaled that a trade deal would be signed with the potential for existing tariffs to be cancelled in stages until a Phase 1 deal is signed. Treasuries ran with the possibility of a removal of the September tariffs as part of a Phase 1 deal and staged a massive “relief sell-off” on the back of these headlines. The selling took place in the context of large volume and was mostly concentrated in the belly (5-10yr sector). The 10yr Treasury traded in a 17bps intraday range (below) when the trade headlines first hit the tape with the equivalent of $544bln in 10yr Treasuries changing hands in the futures market. However the lack of a more defined curve reaction (2s30s closed only 2bps steeper) and the outsized move in the intermediate sector was likely indicative of an old fashioned duration shed/risk-on reaction than any acknowledgement of the global growth/inflation implications of a possible truce in trade tensions. At any rate, the combination of relief on U.S./China trade, reduced probability of a disorderly Brexit and increased sovereign supply (French/Spanish) had safe-haven markets on their back foot for the majority of the month.

10yr Treasury Sold Off 17bps Intraday on U.S./China Trade Headlines (Most Since the November 2016 Elections)

Source: Bloomberg, TD Securities

In the background, a set of mostly firm economic data was almost an afterthought as euphoria around a possible trade deal drove risk markets all month. Although stronger-than-expected data around employment, the services sector and personal consumption contributed to animal spirits during the month, the mood was somewhat tempered by manufacturing data that remained tepid. More importantly, various readings on inflation data ticked lower or remained stagnant as inflationary pressures as measured by these statistics remained benign. Although the back and forth in U.S./China trade negotiations is not a direct driver of domestic monetary policy, the positive tones around it certainly gave the Fed some breathing room to gauge the incoming economic data. While this set of data overall has been firm, softer inflation readings will keep the Fed more biased to ease over the next 12 months. As a result, the Treasury curve is more likely to steepen as either front-end rates rally as rate cuts are delivered or actual inflation is generated causing the long end to sell off. However with the economy in a relatively “good place” for now, the Fed remains in a holding pattern with its attention gradually shifting to developing longer-term solutions for stability in the repo funding markets and more importantly, reviewing its current suite of monetary policy tools and strategies with a particular focus on tools to boost inflation/inflation expectations.


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