Bond Markets – the Topic du Jour – October 5, 2018

Bond Markets – the Topic du Jour – October 5, 2018

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Bond Markets – the Topic du Jour

This week we may have witnessed, for the first time in a long while, a paradigm shift. The shift was from tariffs, taxes, and earnings to interest rates – which is really the big enchilada. Once again, stocks rallied to new highs earlier in the week on reduced concerns over tariffs, but interest rates across the curve simultaneously took a major leap higher. The 2-year and 10-year Treasury yields rose 6 and 17bps, respectively (see the scores for the yields).

In the recent past, this type of action has been labeled bullish because rising rates often go hand-in-hand with an improving economy. But on Wednesday this week, traders began to question that notion. Stocks started to decline in a hurry on fears that higher rates would be a deterrent to economic growth (right answer). Of course, it didn’t help either stocks or bonds when Powell started saying that inflation was a problem and the Fed might have to raise rates to the point where it would be restrictive to growth.

The point is that, as I have said here before, rates are moving higher in an intractable state of disequilibrium between supply and demand in the bond market, influenced by our $400 billion unfunded (by foreign creditors) current account deficit. The real question is, did the market take its first step toward understanding this issue, or not? Both bonds and stocks were roughed up this week – and rates were the subject at hand while it was happening.

Turning to the economy for a moment, there is some confusion. The regional impact of Florence has been largely offset by the negative impact of higher rates across the entire country – or so it would seem. Put in simpler terms, the data was mixed. For August, the ISM Manufacturing Index retreated to 59.8 from 61.3 on a fall in prices and orders, Consumer Credit jumped (due to Florence) about 25% to $20.08 billion, and Durable Goods and Factory Orders rose 4.4% and 2.3%, respectively. For September, the ADP Employment change was much better than expected at +230,000, but US non-farm payrolls produced an underwhelming 134,000 jobs. This led the media to celebrate the unemployment rate instead because it fell 0.2 percentage points to 3.7%. And finally, on a rather obscure front, the September Challenger Job Cut Announcement Index rose 70.9% from a year earlier, and is now approaching critical levels.

Away from all that, fixed income markets were weak across the board – no matter the country. Italy has been leading the pack lately, with 10-year rates having moved up nearly 55bps in the latest week. Italy’s budgetary problems are similar to those of Greece, and have reached an inflection point. As a result, Italy would like to leave the EU, but would also like the ECB to keep buying its debt.

The precious metals held their ground through all this – even when stocks declined sharply. Powell’s talk of inflation may have helped, but there’s no evidence that gold is responding to cost-push dynamics just yet. Oil finally took a step back from speculative highs and retraced to the low 74/bbl area. The dollar managed to rally a little, presumably at the prospect of a tougher Fed and higher rates. Next week, third quarter earnings announcements begin with JPM and Citigroup on Friday. The PPI and CPI releases will give us a look at price activity for the month of September.

Best Regards,

David Burgess
VP Investment Management


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