"Don't fight the Fed" has always been a very popular piece of advice. Make no mistake that the FOMC wants to continue to raise interest rates for the foreseeable future. What holds them back is growth and inflation expectations. The labor market appears to be on very solid footing with unemployment well below the Fed’s target, now at 4.4%. However the labor force is shrinking and wage inflation is relatively low considering how tight the labor market is today. Economic output in the 1st quarter was very weak and most economists believe the 2nd quarter will have much better results. In looking at growth opportunities via legislation it appears the battle over tax reform could drag on for several months and now there is an FBI-Russia scandal that will only slow the legislative process.
Buyers of long term debt are economists in a sense. They invest trillions of dollars in US Treasuries and certainly have an opinion on future growth and inflation expectations. So what happens when the Fed is raising short term rates but somehow long term rates are coming down?Historically that suggests a recession is forthcoming (see grid below). However given sustained buying of longer dated Treasuries by both foreign and domestic investors, the drop in long term rates may be more of a function of supply and demand than short term inflation or recessionary fears. That being said the longer term view of inflation has to be relatively low for a fixed-income investor to make such a low yielding purchase. So what’s that all mean?
Quite frankly the market is telling you what is probably obvious at this point. Short term rates are likely to rise with a tightening labor market and the potential for inflation BUT the longer term view is that rates will remain low because the longer term view of inflation and growth is relatively mute.
If you need further evidence I’ve provided two charts below. The first one is a very sophisticated index that calculates the term premium on the 10yr Treasury. A negative value means that 10yr Treasury buyers are willing to lose money rather than buy shorter term Treasuries. One could argue that means 10yr Treasuries should move higher but more likely the case is that short term rates are moving up too fast. The chart shows that the term premium is still negative and moving lower. The second chart is the Merrill Lynch Option Volatility Estimate (MOVE Index). A lower value indicates Treasury rate volatility is moving lower even as the Fed indicates they plan to raise rates at a potentially faster pace. Put all of that information together and it spells low long term rates for the foreseeable future.
Have a great day.
Short Term Fed Funds Target Rate versus 10yr and 30yr Treasury
Date Fed Target Rate 10yr 30yr
March 14th0.75 2.61 3.19
Today 1.00 2.41 3.03
Change +0.25 -0.20 -0.16