Why I’m betting on higher US bond prices

‘In ordinary times, low or even lower yields on US Treasuries amid tighter Fed policy might seem unthinkable, but we are not living in ordinary times’

PUBLISHED : Tuesday, 05 September, 2017, 9:44am
UPDATED : Tuesday, 05 September, 2017, 10:40pm

In all likelihood the Federal Reserve will continue to tighten US monetary policy. In normal circumstances that might be expected to result in US yields ticking higher. But these aren’t normal times and market participants may have to recalibrate their expectations. Tighter monetary policy might not yield higher rates.

Friday’s US non-farm payroll (NFP) data for August may have underwhelmed, with the 156,000 rise coming in below market expectations of an 180,000 increase, but it probably won’t impact Fed thinking. As the UK’s Barclays Bank noted “the three-month average gain in non-farm employment is 185,000” which is a respectable enough figure.

It could be, as US firm Wells Fargo Securities argued on Friday, that the US “jobs gains are consistent with 2.5 per cent [US] economic growth in the third quarter, steady consumer spending and Fed policy as currently projected for a December rate hike.”

There’s also the likelihood of the Fed embarking on balance sheet reduction later this month.

But there’s a fly in the ointment for those expecting higher US yields and that is that there’s no compelling evidence that US inflation is on the rise.

July’s 1.4 per cent year on year rise in the Fed’s preferred inflation measurement, the core personal consumption expenditures index, released last Thursday, was the smallest increase since December 2015.

Meanwhile, as US bank Morgan Stanley pointed out, Friday’s data also showed that the US “core wages measure, [representing the] average hourly earnings of production and non-supervisory workers, fell to its lowest level since November 2015.”

Already carrying a substantive burden of household debt, the archetypal male US manual worker “Joe Sixpack” can arguably ill-afford even higher borrowing costs.

Though concerns about blue-collar debt won’t drive the fixed income markets, US bond yields remain subdued even though tighter Fed monetary policy seemingly remains on course. Indeed, writing Friday, HSBC continues to see the yield on the benchmark 10-year US Treasury (UST) at 1.9 per cent at the end of 2017, lower than at present, and well below their calculation of a 2.55 per cent consensus view.

HSBC doesn’t see Federal Reserve balance sheet reduction, which represents the start of the roll-back of previous bouts of quantitative easing, as disruptive for the Treasury market. The bank also notes the continuing absence of upward US price pressures and the high level of accumulated debt in the United States, the servicing of which only gets harder as interest rates rise.

Given that HSBC’s 1.9 per cent year-end 10-year UST forecast is substantially below the consensus, the bank’s stance is an outlier position but that doesn’t mean it is wrong.

In some developed economies it already seems apparent that policymakers are nervous about embarking on monetary policy tightening for fear of the consequences that might accompany it. In others, policymakers have absolutely no present intention of going down that path.

Markets had been wondering whether this Thursday’s European Central Bank (ECB) policy meeting would unveil a timetable for tapering off asset purchases but, if unnamed sources cited by Reuters last week are accurate, the current strength of the euro, itself partly predicated on the ECB making such an announcement, has made such an outcome less likely.

The ECB is conscious that the stronger euro has a disinflationary impact on the price of goods imported into the euro zone while simultaneously making euro-denominated exports less competitive outside the currency bloc.

The ECB may decide to paper over the taper lest the euro soars anew.

And as for Japan, as its central bank’s governor Haruhiko Kuroda made patently clear in Jackson Hole last month, the Bank of Japan bank remains wedded to the concept of Yield Curve Control, which currently incorporates keeping the yield on the 10-year Japanese Government Bond at close to zero.

Back in the United States, it is unlikely that the havoc wrought by Hurricane Harvey or the costs of the subsequent clean-up will dramatically sway Fed thinking even if the weather event should make US economic data a little more difficult to interpret in coming months.

Yet Harvey might have the side-effect of prompting Congress to now approve an increase in the US government’s debt ceiling, which if it occurs, could lead to lower short-end US yields as market concerns about hitting the debt ceiling are allayed. Such a reaction would be independent of market expectations of the Fed’s tightening path.

That brings us full circle.

In ordinary times, low or even lower yields on US Treasuries amid tighter Fed policy might seem unthinkable. But we are not living in ordinary times.