Subdued Inflation to Encourage Fed's Patience

Last Week: Interest rates stuck to their familiar ranges and equities traded higher as US recession fears tempered. The 10-year US Treasury note rose to 2.49% from 2.42% a week ago, nudged higher on signs of economic stabilization in China and continued hopes for a resolution of the US–China trade standoff. 1-month LIBOR fell to 2.4735% from 2.4933% this time last week. Oil prices continued to firm, rising to $62.60 from $60 a week ago as the US Dollar and Gold both rose. Treasury yield volatility fell to 3.62 from 3.91.

The Good: US hiring rebounded more than forecast in March and the prior month was stronger than first reported, relieving concerns about a cooling economy. Business inventories rose 0.8% m/o/m, above the expected 0.5% increase. Construction spending rose 1.0% m/o/m, beating the expected 0.2% decrease. Overall, the data allayed concern that America’s pace of growth is headed for the ditch and supported the small rise in bond yields seen last week.

The Bad: Retail sales fell 0.2% m/o/m, missing the expected 0.3% increase. The PMI manufacturing index slowed in March to 52.4, below the previous 53.0. Durable goods orders fell 1.6% m/o/m, lower than the previous 0.1% increase.

America’s jobs engine sputtered back to life. After posting a paltry 33K rise in February, nonfarm payrolls rose by 196,000 in March. Wages – the critical ingredient for consumer’s continued spending – rose a weaker-than-expected 3.2%, down from cycle highs of 3.4% last month. The unemployment rate held steady at 3.8%. Weekly US jobless claims fell to 202,000, almost a half-century low, indicating that the US labor market remains robust. While greeted with a sigh of relief, the three-month average number of new jobs has declined to a 15-month low of 180,000, signaling a new, downward trend. This, combined with the slowdown in wage growth, confirms that the Fed will remain on the sidelines for the foreseeable future.

Brexit negotiations seemingly drag on and on. You may have noticed that we’ve spared you the soap opera drama of the UK-EU Brexit negotiations. Having already extended the negotiating period by two weeks, the British Parliament is no closer to a Brexit resolution than it was prior to the delay. While the saga will be with us for quite a while yet, we doubt that it will have any lasting impact on US Treasury yields or interest rates in general. Until some real breakthrough occurs that changes our opinion, we won’t mention it again. You’re welcome.

US-China manufacturing gauges bucked the global slowdown trend. Purchasing managers’ indices show that the manufacturing sectors of the US and Chinese economies showed signs of improvement in March. America’s primary manufacturing gauge rose to 55.3 from 54.2 in February. In comparison, China’s composite PMI, which combines both manufacturing and service sector PMIS, rose to 54.0 last month, a jump of 1.6 points from February. The data contrasted sharply with that of the eurozone, where a similar gauge fell to 51.6 from 51.9 the prior month, weighed down by a slump in Germany, where the gauge fell to its lowest level in nearly six years.

The European economy is looking increasingly worse. Germany’s leading economic think tanks have collectively slashed their 2019 economic growth forecasts by more than half. The institutes now project the German economy will grow just 0.8% this year, down from their 1.9% forecast last fall. The fallout from the US-China trade war and the ever-lingering Brexit uncertainty are holding back Germany’s export-reliant economy. Being the economic lynchpin of Europe, as Germany goes, so does the rest of Europe. With the German 10-year Treasury yield at just .002% – yes, you read that right – a slowing Europe will serve as a drag on US Treasury yields moving substantially higher.

What to Watch This Week: While the handful of important data releases last week indicated that the recent lull in economic activity in Q1 was temporary, all eyes will look toward measures of inflation for confirmation that it isn’t a threat. Such an outcome would further imply that the Fed will indeed sit on its hands for a long while yet.

Wednesday’s Consumer Price Index (CPI) and Thursday’s Producer Price Index (PPI) reports – both broad measures of inflation on the consumer and business level – are widely expected to fizzle. If so, it will take an upside surprise in Chinese manufacturing data or European CPI figures to move interest rates around in any significant way.

In addition, Wednesday’s release of minutes from the March Fed meeting will give markets more insight into the Fed’s thinking on how it’s meeting its 2% inflation mandate. We expect the minutes to show that further rate hikes are indeed off the table, but doubt they’ll show any explicit discussion of rate cuts which many in markets have been forecasting lately.

Take-Away: While the significant decline in Treasury yields in March seems out of step with the tight labor market and rebounding economy, it makes sense when considering the market’s grim outlook for inflation. One can get a sense for how financial markets are forecasting inflation by looking at the market for something called Treasury Inflation Protected Securities, aka “TIPS.”

In short, TIPS are a US Treasury bond that is indexed to inflation in order to protect investors from the negative effects of rising prices. As inflation rises, the value of TIPS rises, protecting their owner from inflation. Simple – got it?

Right now, the TIPS market is showing that inflation will stay well below the Fed’s target for years to come. When combined with the Fed’s recent downward revisions to economic and interest-rate projections, you get a sense of why Treasury yields have declined so much in recent weeks.

The fly in the Chardonnay in all this is growing talk that the Fed will soon redefine how it views inflation and questions on how this change will also change the way the Fed responds to inflation (or lack thereof) by hiking or cutting interest rates. Our first clue of such could show up in this week’s release of the March Fed meeting minutes. We’ll keep you posted.

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