Originally posted at Briefing.com
You might have heard that the Federal Reserve is thinking about raising the fed funds rate before the end of the year. The Treasury market certainly has and you can see as much at the front of the yield curve. What's happening at the back end of the yield curve, though, is raising a number of questions, one of which is whether a rate hike from the Federal Reserve might be forestalled until sometime next year (or maybe the year after that... or the year after that).
The Theory of Evolution
The growing possibility of the Federal Reserve raising the fed funds rate has been pricing itself into the front end of the Treasury yield curve, into the U.S. dollar, and into the stocks of banks, which will benefit from higher short-term rates that allow for some needed loan pricing power.
The prevailing narrative driving the jump in yield for the 2-yr Treasury note is that economic activity is picking up and is expected to accelerate in coming quarters. That view stems primarily from the improvement that has been seen in the labor market, the surge in house prices, the continued increase in equity prices, and the sharp drop in energy prices that has provided consumers with more discretionary spending potential.
[Read: Market Update - Recession Risks, Credit Markets, and Investor Sentiment]
Admittedly, there is more to the economic argument than those positive factors. There are negative considerations, too. We aren't going to delve into it all here.
The salient point is that the Federal Reserve calls the rate-hike shots and at this juncture it's looking for the U.S. economy to continue to evolve in a manner that would warrant a rate hike before the end of the year.
But will it?
Around and Around
Last week we touched on the point that a number of key areas with leading indicator status are lagging badly this year, namely transports, semiconductors, and copper. Lumber can be thrown into that mix, too, with lumber futures down 19.5% year-to-date.
In fact, a lot of commodities have been on the market's chopping block this year, which is peculiar knowing that many serve as building blocks for a strengthening economy. Copper, oil, lumber, and aluminum alloy are some notable examples where futures price trends have not lined up with the Federal Reserve's economic eye.
That reality is leading some market participants to think there is more than meets the eye — or, really, less than meets the eye — in terms of the commodity price weakness and what it is saying about future economic activity.
It's a conundrum of sorts, because a contributor to that price weakness is the U.S. dollar's strength — strength that has been fueled in part by the understanding that the Federal Reserve is eager to raise the fed funds rate.
Commodities are dollar-denominated, so when the dollar increases it becomes more expensive for foreign buyers to purchase those commodities. That can crimp demand, which then increases supply and leads to lower prices if producers don't cut back on production. In time, the lower prices should stoke increased demand that absorbs the excess supply and drives prices higher.
In effect, then, the market is caught in a traffic circle and it's not quite sure which turn to take. Consequently, we keep going around and around with three competing ideas that weak commodity prices are owed either to: (1) the dollar's strength (2) overproduction by producers that has led to a supply glut or (3) an actual slowdown in end demand that is being exacerbated by the dollar's strength.
Some might say a fourth idea — all of the above — also applies and that is a fair position.
But Why?
What can be gleaned from the back end of the yield curve, which is more inflation sensitive, is that it isn't all that concerned about rising inflation pressures.
That view is at odds with what's going on at the front of the curve considering the Federal Reserve has said it will raise the fed funds rate when it has seen further improvement in the labor market and is "reasonably confident" that inflation will move back to its 2 percent objective over the medium term.
[Hear: Axel Merk: The Fed May Raise Rates, But It Will Remain Behind the Curve]
From our vantage point, confidence about the inflation trend can't be all that high right now with commodity prices weakening and the dollar strengthening. Those two forces aren't inflationary. They are disinflationary.
The latter understanding is one reason why the spread between the 10-yr note and 2-yr note has flattened of late. It had been steepening some since the start of the year, but even at its steepest point this year (177 basis points), it was still 22 basis points lower than the spread seen a year ago.
We mention this as only "one reason" why there has been some flattening of late. There are some other valid considerations that also need to be taken into account.
- The fear of a misstep by the Federal Reserve, which is sounding anxious to raise rates at time when the U.S. economic data remain squishy, solid wage growth is still lacking, China is slowing, and the eurozone is only just starting to show signs of economic improvement.
- The expectation that future rate hikes will come at a slower pace and ultimately result in a maximum fed funds rate that is lower in the next tightening cycle than what has been seen in previous tightening cycles.
- The renewed appeal of the safety trade in US Treasuries following the Greek bailout drama and the stock market volatility in China.
- Interest rate differentials.
- Granted sovereign yields in Europe have risen noticeably from their lows, but the 10-yr Treasury yield (2.27%) still looks good comparatively to European buyers looking at a weakening euro and a 0.66% yield for the German bund. Longer-dated Treasuries probably aren't looking all that bad either to anxious Chinese investors.
A sixth reason for the flattening — all of the above — also applies and that is a fair position.
What It All Means
In deference to the section header, it isn't possible to know what it all means right now. The viewpoints being priced into the front end of the Treasury yield curve and the back end of the Treasury yield curve are not complementary in nature.
Short rates are going up on the idea that the Fed will soon raise the fed funds rate because the economy is getting stronger and inflation will be moving toward its 2 percent objective. Long rates are going down for a variety of reasons, yet there certainly isn't any strong belief that the U.S. economy is picking up to such a degree that a spike in inflation and inflation expectations is in the offing.
On the contrary, there are disinflationary forces at work and there is concern that, if the Federal Reserve goes ahead with raising the fed funds rate in the near term, it will impede recovery efforts and contribute to the disinflationary forces.
The yield curve should be steepening in a move of confidence about economic potential. Instead it seems to be flattening in a move of doubt about that economic potential.
[Hear also: Jim Puplava’s Big Picture: Slow and Shallow – The Next Fed Interest Rate Cycle]
The Federal Reserve talking about raising the fed funds rate at an uneasy time for the capital markets is contributing to that doubt along with the stronger dollar, falling commodity prices, and the recognition itself that the yield curve is flattening. If the flattening persists as a consequence of weak economic data that pushes back rate hike expectations, then the bank stocks would be subject to a bout of renewed weakness.
At the moment, both the stock market and the Treasury market are caught in a traffic circle and don't know where to turn, so they keep going around and around.
From our perspective, the flattening yield curve is a flashing yellow light right now signaling to proceed with caution.
