Last week I said for the bullish scenario that Z8Z0 could get to the low (28.5) and we may be able to rally 10bps.  Well, that’s what happened.  We had several pieces of bullish news: (1) the lower CPI on Friday, (2) The Fed being concerned with “non-transitory” low inflation from the minutes, (3) the strong bond auction despite potentially strong economic data the following day, (4) Trump cutting back on healthcare payments (higher costs to consumers and potentially slowing the economy), (5) Trump decertifying the Iran deal, (6) a non-hawkish ECB taper plan, (7) no progress on tax reform and (8) Taylor fading and Powell building a lead on Warsh (47 to 25).  The market positioning is still probably short, so that added to the rally.  But on the hawkish side, we got better US growth data and no new North Korea news.  Some of the bullish news was a bit of a surprise.  We constantly need to adjust our view, based on the current news.

The most interesting part of the curve is the longer end.  We expected the markets to grab for yield in the longer end after the resistance on the tens yield downtrend line held, and we thought the longs would hold off buying until CPI and Retail Sales.  Now that some of the longer end year spreads in EDs are at or below support, it will be interesting to see what the curve does next week on relatively little new economic data.  What I find particularly interesting is that the grab for yield in the very long end of the US curve, relative to the other curves.  I realize the US has started its hiking cycle already, but if you were going to grab for yield in bonds, I’m not sure the US is the one I would go for right now.  The ECB is going to be buying for almost another year, and the BOJ is going to be buying for what could be forever (I would just be afraid Japan would implode).  You get more carry on the other curves.  If the longer end does flatten further in the US on a rally, that would be a surprising development.  I’m guessing there must be some kind of “hammer the highest yield” (without looking at relative value) mentality going around.

Here is what we know and what we should be asking ourselves:

  • “Many” at the Fed are concerned about structural forces keeping inflation lower. And we just saw another low inflation print.  The question is, what does low inflation do for the economy and Fed policy?  Low inflation most certainly could cause a shallower hiking path, with the Fed concern about low inflation.  But isn’t that what is priced in?  Is high growth plus low inflation going to cause less than one hike to be priced in for 2018?
  • To what degree is inflation “transitory”? I’m not sure what “transitory” means.  The example most often used is the mobile service prices.  But shouldn’t that be going down every year?  I pay over $250 a month and that seems absurdly high – especially when things like digital services should continue to get lower.  Should medical prices count when we are in the middle of a potentially major structural change in drug and healthcare prices?  I’m starting to wonder if the Fed thinks wages are a better measurable and leading indicator of potential pricing stress in the economy.  They certainly act like it.
  • All other things being equal, lower inflation (especially if it is structural), should cause the longer run FF rate to be lower. This would also imply lower rates for longer term Treasuries.
  • However, all things are not equal. This is because we have stronger growth and some signs of wage pressures.  We also have a Fed that is willing to be more patient on inflation.  Remember the yield spike after Yellen’s “hysteresis” comments last year?  A patient Fed in the face of growth should mean a steepening of the curve.  So we need to watch the interplay between inflation (and to the degree the changes are structural) and higher wages.  Weighing the data from the previous two Fridays (Employment Report and CPI), I’m not sure that equals a lower longer run FF rate.
  • Stronger growth should cause the Fed to hike in Dec. Most of them implied that they were on board for another hike if growth held up.  There is currently 19bps priced for the Dec meeting.  Before last week, I would have said that was a little low (since I assumed the CPI data would come in-line).  Now I think it’s closer to fair (and possibly a little high).  This is mostly because there are four voting doves this year, and we still have the debt/budget deadline a few days after the Fed meeting.
  • Recession odds have not changed. One way to try and reconcile the few 2018 hikes priced in is to estimate the probability of a recession and multiply it by the amount of accommodation the Fed may provide.  The WSJ’s economist survey has had the chance of recession next year as 16% for some time now.  Even if you assume the Fed eases 100bps, that only gets us to 16bps of EV (expected value).  Where did the rest of the 2018 hikes go?  I like the idea of looking for underpriced 2018 meetings (relative and absolute).
  • I will be the first to admit that the Fed and ECB are both taking things VERY slowly. According to the WSJ, we probably won’t see an actual reduction in total central bank balance sheets until 2019.  But aren’t EDs supposed to be FORWARDS?  Somehow 2019 is going to roll around, the central banks are starting to reduce their assets and forward rates are going to stay low?  This does not compute.  The one constant is the BOJ.  However, at some point, with an imploding population base, aren’t the currency and bonds going to get trashed?
  • Is term structure ever coming back? The markets clearly don’t think so.  But as the central banks reduce their balance sheet, I can’t imagine the term structure doesn’t come back eventually.

If the employment report was next week, I would feel better about being bearish.  But we have very little new information next week.  In terms of economic data, the main thing I’m curious about is if there are additional qualitative signs of wage pressures in the Beige Book.  The next 5 bps could be either up or down, although the momentum is clearly higher (lower yields).