Inflation Data to Support Fed Pause
What You Missed
The past week saw signals that the jobs market is indeed softening, adding a tailwind to a slow but steady evaporation of inflation pressures. Paired with growing labor productivity – mostly due to workers putting in less hours on the job – the data supports our belief that the Fed will keep rates steady for an long while, likely through the end of the year. Also, of note last week was a surprise steepening in the Treasury yield curve. While welcomed, the change unnerved markets since the steepening resulted from a painful selloff in longer term bonds (price down, yields up) rather than a rally in shorter term debt (price up, yields down) that most have hoped for. New to yield curves? Check out our explainer.
Running the Numbers: Spike in Long Term Yields Rattled Markets
For the week, short-term yields fell, as longer-term yields rose (aka a “steepening” curve):
- 2-year Treasury yield: down 9 basis points to 4.79%
- 5-year Treasury yield: down 2 basis points to 4.16%
- 10-year Treasury yield: up 10 basis points to 4.07%
- 30-year Treasury yield: up 22 basis points to 4.23%
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose just one basis point to 5.37%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell 16 basis points point week over week, to 4.31%, reflecting the view that the Fed is done or nearly done with rate hikes.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and forecasts that it will peak in the fall, at 5.40% (remember, it’s 5.37% right now), then decline consistently over the next year as the Fed eventually eases.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, finished the week higher, on the back of the spike in long term Treasury yields. Elsewhere, equities were lower in the week amid a spike in long-term interest rates. A sharp rise in oil prices contributed to the rise in yields as a barrel of West Texas Intermediate crude oil firmed $2 to $81.85.
Surprise Curve Steepening Hits Markets – Should You Care?
For the first time since June, 30-year US Treasury bond yields rose above their five-year counterparts last Thursday to 4.29%, close to a decade high, driven there by resilient economic data and better-than-expected corporate earnings, which inspired the belief that Fed will tame inflation without a severe economic slowdown. This growing expectation of an economic “soft landing” requires the US Treasury to offer higher yields on long-term debt it sells. The 10-year yield settled at 4.06%, slipping after a soft monthly jobs report. That was up from 3.97% a week ago and within touching distance of its 14-year high of 4.231% from October.
The rise in long-term Treasury yields was also aided by the US Treasury’s decision to boost the size of its quarterly bond sales for the first time in more than two years last week to help finance a surge in budget deficits (increase supply of bonds, prices will fall = yields rise). The announcements of increased issuance and Fitch Ratings’ downgrade of its US credit rating (read below for details on the downgrade and what it means) added significant fuel to the sell-off of long-term U.S. bonds.
To refresh your memory, markets expected that the Fed would keep hiking rates to fight inflation and then cut them once a recession occured, which caused short-term Treasury yields yields to rise well above those on longer-term bonds, and inverting the yield curve. Now, the opposite is happening. Shorter-term Treasurys have benefited from signals from the Fed that it is at or near the end of its hiking cycle. However, by allaying worries that its aggressive rate hikes would trigger a downturn, the Fed has helped to fuel the selloff in longer-term bonds.
Should you care? Probably. If the steepening momentum continues, and the move ends up being a true and lasting shift, the interest rate on that “slam dunk” fixed rate loan you just closed may not look so great nine to 12 months from now.
Why Fitch’s US Downgrade Matters
Fitch cited an anticipated fiscal deterioration in America’s finances over the next three years and a deteriorating, dysfunctional government as reasons for downgrading the US government’s credit rating one notch, to AA+ from AAA, last week. The announcement, coupled with news that the US Treasury plans to boost the size of its quarterly bond sales for the first time in more than two years to help finance a surge in budget deficits, reminded markets of America’s unsustainable fiscal path of rising debt as a percentage of GDP.
If you’d listened to the financial news media last week about the downgrade, you’d have thought the world was ending. However, financial markets responded with a collective shrug, knowing that the dynamic is real, but that it won’t change anytime soon. For some perspective, the last time a credit rating agency downgraded the US was in 2011, when Standard & Poor’s (S&P) downgraded the US following the 2011 debt-ceiling standoff. Back then, the nation’s debt to GDP ratio was 66%, and at the time, it was projected to increase to 77% by 2021, which S&P deemed to be an unsustainable trend. The debt-to-GDP ratio is now anticipated to reach 98% this year, and at the current run rate, will increase to roughly 130% by 2033. Yikes!
For us, the worsening US fiscal position certainly deserves more attention, both for what it indicates about the likelihood of a recession this year and what it means for longer-term debt sustainability. Comparing the first half of the current fiscal year to the same period in 2022, Treasury receipts are down $423 billion, while outlays are up $455 billion, including $131 billion in interest payments. The aggregate deficit is $878 billion higher than it was during the same time last year. From what we’ve read, lower receipts from individual income taxes are mostly to blame.
History tells us that tax receipts and the fiscal deficit usually improve in times of economic prosperity. Hence, one’s expectation of an economic “soft-landing” doesn’t jive with the lower tax receipts and deteriorating fiscal situation our government is currently experiencing. Just remember that fiscal receipts and the deficit both declined as the recessions of 2001 and 2007 approached. It’s yet another piece of evidence that America’s economy side-stepping a recession shouldn’t be a forgone conclusion.
Cooling Jobs Market Helping to Smother Inflation
In what is always the single most impactful piece of economic data on interest rates, markets stood up and paid attention to last Friday’s read on the state of the jobs market. The jobs data showed that the job market is becoming more fractured as the headline number of new jobs created in July (+187k, less than the 200k expected) fell short of forecasts, and June’s job data was revised lower (-185k). It was the second straight negative surprise. The two-month net revision was -49k.
A more robust jobs market was implied by the household survey, which showed a 268k increase in jobs (vs. 273k prior), as the labor force increased 152k (vs. 133k prior) and the labor-force participation rate stayed steady at 62.6%. With household employment increasing by more than the rise in the labor force, the unemployment rate fell to 3.5% (vs. 3.6% prior).
Our take: While still solid, the data, showing a second consecutive month of smaller increases in new jobs, confirms that the jobs market expansion is slowing. The question now? Will the cooling continue a slow and steady path, or will it follow the more typical historical pattern: first slowly, then steeply? On the surface, July’s 187k in new jobs demonstrates a robust job market, but history suggests that pace offers little comfort about what could be lurking around the corner. For some perspective, just two months before the Great Recession began in December 2007, monthly hiring was growing at a heady 166k, prompting declarations of a resilient jobs market.
What to Watch: Inflation Data will Prompt Fed to Keep Rates Steady in September
Even though many other data points support a different conclusion, financial markets seem to be focusing on data that supports the belief in an economic soft-landing, where America’s economy experiences a short, shallow recession, or avoids one entirely.
The 30-year US Treasury yields’ 20-basis-point rise last week, a huge shift by historical standards, is offering a reality check. If sustained, a move in yields of this magnitude and pace usually wreaks havoc over time. When combined with an economy suffering the lagged effects of over 500 basis points of Fed rate hikes, the risk of a new, undesirable credit event is high.
If long-term rates remain high, the economy will suffer. Many believe that housing prices have bottomed out, but rising mortgage rates – a direct result of higher long-term Treasury yields – could spur them to fall anew. Corporate bankruptcies and consumer credit defaults are also on the rise, and this week’s release of data on lending (Nat. Federation of Independent Businesses survey, Tuesday) and consumption (import activity, also Tuesday) will provide signals on how much both have deteriorated. As a result, the latest read on the state of inflation (Consumer Price Index, Thursday; Producer Price Index, Friday) will likely confirm that inflation is sustainably on the retreat.
There is always a chance that fresh supply shocks might undo the Fed’s progress in smothering inflation, such as drought conditions in the Panama Canal, El Nino weather patterns, labor strikes, or rising global energy prices. Because of this, the Fed will be reluctant to make a quick switch to interest rate cuts, which in turn would make any economic downturn even worse.