Do Larger Deficits + A Smaller Balance Sheet = Higher Rates?

Last Week: Interest rates and equities both lurched higher amid continued evidence of synchronized global growth and solid corporate earnings. Yields on US 10-year Treasury notes rose to their highest level since 2014, trading to a weekly high of 2.66% last Friday morning. 1-month LIBOR followed the 10-year higher, trading to 1.5613% from 1.5561% the week prior. Oil and the US Dollar traded mostly flat, while Gold fell. Treasury market volatility, as measured by the Chicago Board Options Exchange Treasury Volatility Index (TYVIX), jumped to 4.27 from 3.66 a week ago.

Failure of immigration compromise forced a US government shutdown. It’s all over the news elsewhere, thus we’ll not go into detail here. Just know that a short-term shutdown is minimally disruptive to markets, but a long-term shutdown could prove more unsettling, spurring market volatility.

Trade frictions garnered increasing market attention. Markets are beginning to grow concerned that escalating trade tensions could weigh on investor confidence. With another round of NAFTA (North America Free Trade Agreement) negotiations set for this week and several US Department of Commerce investigations into Chinese trade practices winding up soon, investors fear tit-for-tat trade sanctions between the US and Canada, China and Mexico will disrupt a period of unusually synchronized global economic growth.

US jobless claims fell to 45-year lows. Weekly US jobless claims fell to 220,000 in the week ending 6 January, the lowest reading since 1973, when the US population was far smaller than today. The US Department of Labor reported last Friday that the US unemployment rate held steady at 4.1% In December.

What to Watch This Week: Outside of the political theater, the week ahead looks to be a sleeper. A sparse data calendar combined with the beginning of the communications blackout period ahead of the Fed’s January 31 meeting will force the market’s attention toward US politics, specifically the government shutdown and the looming debt ceiling negotiations.

On the data front, Friday’s release of the first of three readings of Q4 US GDP will be watched intently for a much hoped-for print above 3%. We’re skeptical that we’ll see US growth at that level this time around, as the pace of consumer spending – the driver of America’s growth over the last several quarters – has been stable, thus limiting the extent to which growth can consistently outperform the 3% threshold. Regardless, even a reading just below 3% would still put the US on the fastest pace of growth since mid-2015.

Markets will also be focused on Treasury yields – more so than usual – amid a slew of auctions and markets at multi-year highs.

Take-Away: This week’s ramp up in US Treasury bond issuance highlights two distinct factors that many say will provide a tailwind to higher yields in the months to come: The Fed’s actions toward shrinking its balance sheet, and the US government’s increasing financing needs resulting from the recently passed tax cuts and spending increases.

Logic says that if the Fed slowly but surely disappears as a buyer of Treasuries due to its balance sheet unwind, and others (e.g. the world’s central banks) aren’t there to replace them, then Treasury prices will fall / yields will rise as demand for them wanes. To throw gas on the fire, the US Treasury’s increase in sales of debt in the coming years to fund the growing Federal deficit should add even greater upward pressure on yields.

While its tantalizing to conclude that these factors will drive yields significantly higher, don’t be fooled. Markets don’t function that simply. Macroeconomic fundamentals, like the rate of inflation, the unemployment rate, consumer demand for goods and services, etc., are the true long-term drivers of interest rates, as they hold much greater sway over supply and demand for debt and the Fed’s direct actions of hiking or cutting interest rates. Experience has taught us that relying on the influence of a couple of dominating factors to tell us where rates are headed over the long run is a mistake, and that its critical that borrowers maintain flexibility in their risk management decisions or risk suffering the negative consequences of markets not moving as planned, which is often the case.

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