“Monetary policy will, as always, respond to the economy's twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals.”
-Janet Yellen
We took the first peek at 2% on core inflation in 2016. The “2%” level was targeted officially for the first time by the Fed in 2012, the last year in which core inflation sustained a level above 2%. After undershooting for four years, Core Inflation breached 2% in 2016 while Headline Inflation has only recently flirted with the 2% target.
Perhaps surprisingly if you feel you’ve been beaten over the head with it for eternity, the inflation targeting by Central Banks is still relatively new. The central bank of New Zealand was the first to adopt an official inflation target back in 1990. The Fed pursued an unofficial inflation target over a long period, only making its policy official in January of 2012, when it announced that it thought a policy which targets a 2% rate of inflation "is most consistent over the longer run with the Federal Reserve's statutory mandate".
Back to the Global Macro Grind…
The financial asset implications of #Reflation’s Rollover which was a segue from our Q1 2017 macro theme of #Reflation’s Peak, have pressured nominal rates and put a range on real interest rates. As we’ve highlighted, the implications of this shift have played out with real-growth sector outperformance in equities - tech and consumer discretionary.
Indeed, a large swath of inflation indicators continues to conspicuously validate reflation’s rollover.
Aside from the CRB Index, Core PCE revision trends, CPI readings, and Prices Paid the prices paid component of ISMs we want to hash out the inflation premium component of the move in nominal yields in 2017.
Which is it?.. Growth expectations, inflation expectations, or a little of both?
Arguably a decline in the inflation premium component has been the main contributor in the retreat from YTD highs in March to the YTD lows currently. That’s our lens – we’re real growth bulls. The growth slowing vs. real growth accelerating debate is an important one when contextualizing the months-long move in the curve:
- 10Yr nominal yields are -50bps off the YTD high and -30bps YTD
- 5Yr nominal yields are -40bps off the YTD highs and -20bps YTD
- However, real 10Yr yields using core CPI as a proxy for the inflation premium, while 20bps off the YTD highs at +40bps, have still widened out +20bps in 2017 compared to a -30bps move in the nominal yield.
- The yield spread (2s-10 yields) is at a fresh YTD low at +85bps, having declined from +125 bps in March, but the relative shift in shorter vs. longer-term inflation expectations adds much needed context..
To get more specific on inflation expectations, the move in break-evens and inflation swap rates (i.e. market expectations around the path and magnitude of inflation) makes up much of the difference in the high to low range in nominal yields. Shorter to intermediate term inflation expectations have been hit hardest.
- 1 and 2-yr inflation swap rates have since retreated by 55bps and 45bps, which compares to 5 and 10-yr inflation swap rates which have retreated ~30bps.
- When comparing 5 and 10yr breakeven inflation rates to the decline in nominal treasury yields, the inflation component makes up much of the decline. 5 and 10yr break-evens are ~30bps off YTD highs, which compares to nominal yield compression for the 5 and 10-yr of 40bps and 50bps respectively.
- The Fed’s 5YR5YR forward breakeven inflation rate has retreated 20bps off the YTD highs. To simplify, the Fed created the rate in an attempt to estimate the inflation premium/compensation component of holding treasury bonds.
- In today’s Chart of the Day, we show the performance of a TLT/TIP ratio index YTD. This ratio index represents the performance of long-duration treasuries (TLT) relative to Treasury-inflation protected securities (TIP). The ratio index only slightly lags the performance of TLT YTD with reflation’s rollover the “divergence” factor. TLT is +5.3% with the TLT/TIP ratio index +4.0% YTD (+1.3% for TIP).
The decline in inflation expectations and its effect on the inflation premium component of fixed nominal future cash flows is essentially undeniable however you want to slice it. Read Janet’s quote at the top. The Fed cares, and we believe the market has probably changed its assumption on the timeline for prospective policy (fiscal and monetary) implementation more so than truly downgrading the growth outlook.
Any shift in near-term expectations isn’t as visible as longer term expectations. The implied bid yield on July and August Fed Funds futures contract expiries has continued to rise while the implied bid yield on November and December expiries hasn’t budged. In fact the implied yields on those longer duration expiries are actually lower than they were back in March at the YTD highs in treasury yields.
#Reflation’s Peak to #Reflation’s Rollover as it has played out in asset class and subsector returns throughout Q2, is consistent with a QUAD 2 (Q1 2017) to QUAD 1 (Q2-Q4 2017) shift, and it’s why we’ll continue to pound the table on our preferred real growth exposures… until the data changes of course.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.12-2.29% (neutral)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 6 (bullish)
Nikkei 190 (bullish)
DAX 121 (bullish)
VIX 9.48-11.56 (bearish)
USD 96.20-99.15 (neutral)
EUR/USD 1.10-1.13 (bearish)
YEN 109.02-112.16 (bearish)
GBP/USD 1.27-1.30 (bullish)
Oil (WTI) 46.41-49.01 (bearish)
Nat Gas 2.90-3.20 (bearish)
Gold 1 (bullish)
Copper 2.49-2.59 (bearish)
Good Luck Out There,
Ben Ryan
Macro Analyst
