Gundlach and Dalio were out last week saying that rates have more to climb.  I agree in the longer term (I think ten year yields are more likely to make new highs than new lows), but I’m not sure about direction in the short term.  Nothing in the past few weeks has really changed the “weakish US data and the Fed doesn’t have much to hike” narrative.  The only thing that happened was that some central bankers (especially Super Mario) sounded a little hawkish.  Sounded hawkish, but you know he’s going to act dovish for as long as he can.  This selloff has been Draghi-based, and the US has gone along for the ride.  Last week, ER whites-golds steepened 12.2bps, and ED whites-golds got pulled for 7.6bps.  But what I thought was interesting was that most of the move in ER was in greens-golds (steepened 7.2bps, since the ECB won’t be hiking for a while), while in the US, most of the move was in whites-greens (steepened 8bps).

The flattener was a very crowded trade and I think we are seeing that capitulation.  In retrospect, unless you thought we were going into a recession, EDH8-H0 from the low 40s (currently 60) was fairly absurd given the recent selloff on “nothing.”  As I had been saying for a few weeks, the year spreads seemed to have been at “skin and bones” levels – especially ahead of a well-telegraphed Fed taper.  I just wasn’t sure if there was some upcoming recession that wasn’t coming through in my crystal ball.[1]  The data surprises just kept coming overwhelmingly in one direction (down) and we couldn’t really get as aggressive as I would have liked during the madness.

A related effect of an overly aggressive flattening positioning by the markets is that the hikes in the whites got overly priced (visualize a see-saw).  Core CPI is at 1.4% and most of the non-idiot FOMC members (you know who you are) have suggested they need to see inflation rising.  Two weeks ago, I said “the markets are discounting the odds of a pause.”  Since that time, EDZ7 has sold off 4bps, while the greens have sold off 24.5 bps.  I suppose when greens sell off almost 25bps, EDZ7 has to get carried a little for the ride.  And part of that was just EDZ7-FF widening.  But in the past three days, EDZ7 has actually rallied 2bps while EDZ9 sold off 4 bps.  I think this could have some more to go.  Next week (Yellen, CPI, Retail Sales) could provide some more clues as to how much more we are going to steepen (if at all), and in what shape.

Now that I know I’m not losing my mind, I want to summarize the key points related to where we stand right now:

  • The growth data in the US has been unspectacular but very constructive. The labor data has been fairly solid.  2% GDP is not terrible.  And I suppose while people have jobs, and people are feeling good about the future (survey data), we’ll keep chugging along.  If payrolls keep increasing at a 180K pace (the six month average), we’re going to keep growing, the neutral rate will keep rising and the Fed will keep hiking gradually (possibly over years).
  • The inflation data has been poor. There is no wage pressure.  Oil is looking lower.  The only hope for inflation hawks may be in housing prices, the weakening dollar and maybe something like Chinese inflation (data Sunday night).  I’m not really holding my breath.  I’m in middle America, and most things seem to be getting cheaper.
  • The next Fed move is going to be the taper. Pretty much every FOMC member has implied this.  The Fed has been concerned about stability risks and high equity valuations.  As we have seen, raising rates does nothing.  Hiking rates when we are so close to the neutral rate is just a serious donkey move with only 2% growth and NO inflation ANYWHERE.  Unwinding the balance sheet (a relative selling of the long end) will more directly address their concerns.
  • The EDZ9 1yr fly is still low. I’m not sure if this is a sign that more flatteners have to unwind, and/or if this is just a sign that ten year yields are going to stay relatively low because of the JGB peg.  I’m actually going to look more carefully at the BOJ meeting later in the month (later post).  It was a little strange that we sold off 9.5bps last week but greens-golds in the US actually flattened 0.4bps last week on a reflating curve.  We may be just taking a pause, but the price action next week could be more telling.  All other things being equal, I would think we keep reflating going into the Fed taper.[2]

We have Yellen next week, and she is undoubtedly going to be positive on jobs, and how jobs should feed through the rest of the economy.  The big question is, is she going to sound as confident that inflation will eventually head in the right direction?  The central view is probably that she sticks to the status quo that inflation will eventually get to their target – especially since she is about to ride off into the sunset (barring a renomination).

But I think the tail risk is that this inflation normalization belief is expressed in a manner that is less confident.  I had previously said she tends to ignore one or two bad data prints.  How about three consecutive declining yoy core PCE prints?  From a hopeful 1.8% yoy to a dismal 1.4% yoy.  Remember 2013-2015, where the Fed refused to hike (other than Dec 2015)?  The average core PCE for that three year period was… 1.35%.  There is no inflation!  There should be no rush.  The people on the FOMC are mostly economists (scientists of sorts), and scientists tend to reevaluate hypotheses when the results show otherwise.  In the minutes of the June meeting, there were five mentions of “monitor inflation,” so she is aware of the situation.  We have also heard a number of FOMC members say they need to see signs of inflation before proceeding on a tightening path.

If the Fed is cautious about inflation, we probably need to give it some more time before tapering.  As mentioned previously, a taper is a MULTI-YEAR process.  It is highly illogical decision-making to commit to a MULTI-YEAR process when you have a reasonable doubt that inflation will rise to your target.  This may mean a pause in Sept, a Dec taper and no more hikes this year.

Let’s see what happens with Yellen.  We also have CPI and Retail Sales next week.  These events could set the tone for the rest of the month.

[1] As you may have guessed, I got my directional crystal ball in the clearance section of K-Mart.

[2] I could easily see the bulls buying “on the news” though (assuming we keep selling off going in).