The first full trading week of September 2017 saw US interest rates breach the lower end of their recent range, breaking through the key support level of 2.10% on 10-year notes (see Exhibit 1 below).
Exhibit 1: US interest rates recently breached the lower end of their recent trading range (graph showing changes in US 10-year interest rates between 04/01/2016 and 14/09/17)To enlarge graph, please click here Source: BNP Paribas Asset Management, Bloomberg as of 14/09/17
This fall in yields could have signalled a downward resetting of the trading range. But the incursion below the 2.10% level was brief and the rise in yields will likely be further fueled by data released on 14 September showing that the US inflation rate picked up in August after a weak stretch over the last five months. In August the US consumer price index (CPI) rose by 0.4% versus July and by 1.9% on a year-on-year basis. Excluding food and energy, so-called core CPI rose by 0.2% which ends a five-month run of weaker-than-expected inflation data. It will need more readings before we can be sure that this pickup in inflation is sustainable but if it does persist it would raise the probability of a rate hike from the Federal Reserve in December.
The spread between 2-year and 10-year US Treasuries stands at 79 basis points, 20 basis points below its level at the time of the 2016 US presidential election. The relatively flat yield curve is indicative of a lack of confidence among bond investors in the US government's ability to spur growth or any structural reflation of the economy.
Exhibit 2: The spread between 2-year and 10-year US Treasuries has fallen (the yield curve has flattened) since the 2016 US presidential election (graph showing changes in the difference between US 2-year and 10-year interest rates between 08/03/2007 and 08/09/2017)To enlarge graph, please click here Source: Bloomberg, BNP Paribas Asset Management, as of 12/09/2017
Further elevating risk for bond markets are potential policy changes coming out of the meeting of the Federal Open Market Committee (FOMC) on 19-20 September, ongoing geopolitical risk, and the still not fully assessed impact of the devastating weather in the southern US.
We expect the FOMC to keep rates on hold this month and announce implementation of their balance sheet normalization process. The consensus view is that this should lead to higher interest rates, a steeper yield curve, and a general loosening in spreads over time.
Given the Fed’s desire to remove liquidity via balance sheet reduction while simultaneously containing any material pickup in realized volatility, as occurred in the 2013 taper tantrum, investors should be cautious about falling in line with the consensus.
The process will, in all likelihood, take much longer than planned due to weaker growth and slower inflation, leading to interest rates remaining low for longer. This would also mean reduced volatility across spread products, and less opportunity.
Geopolitical risk had been putting downward pressure on bond yields. Even if economic growth and inflation rose, the threat of nuclear confrontation with North Korea would still weigh on yields. Over the last few days developments around Hurricane Irma have taken centre stage, but North Korea-focused headlines could return relatively quickly.
The damage in Florida from Hurricane Irma contributed to yields falling below the 2.10% level. Initial estimates of the cost of the storm’s damage may be lower than initially thought, but the huge destruction wrought by Irma in Florida should not be discounted. Clearly there is an enormous human cost from these events and our thoughts and prayers are with our neighbours in Texas, Louisiana, Florida, Mexico, Puerto Rico and all the affected islands in the Caribbean for their health, safety and well-being.
We ultimately believe that in the aftermath of the hurricanes, there will be a boost in economic data in terms of a small bump to inflation data and a pick-up in government and private spending on the recovery.
It certainly feels as if risk markets are at an inflection point. The excess yield available to the marginal dollar of investment has been greatly diminished. The spread between risky and riskless assets is as low as it has ever been. Credit spreads are close to or tighter than they were going into the 2008/2009 financial crisis. Equity prices have rallied and remain close to their all-time highs, yet interest rates have tested lower levels and the yield curve has not been this flat since the global financial crisis.
The liquidity-induced rally in asset prices feels as if it is at capacity, yet yields started September trading around the bottom end of the range. We are biased to reducing risk into the fourth quarter, as risk feels very asymmetric at this level of yields, and highly susceptible to non-economic factors.
Written on 14/09/2017