How Does The Us. Treasury Note Affect The Fixed Income Bond Market

Information technology's off-white to say that earlier this twelvemonth, central bankers were struggling to communicate their intentions clearly to the markets. However, that doesn't announced to be the instance any longer. In the United States, Federal Reserve Chair Jerome Powell and the members of the Federal Reserve's policy-making Open Market Commission (FOMC) accept been steadfast in signaling their commitment to fighting inflation. If at that place is a communication problem, it'due south mostly that central bankers don't desire to admit out loud that getting aggrandizement downward raises the risk of recession.

European Central Bank (ECB) President Christine Lagarde is facing an fifty-fifty more difficult problem. The ECB wants to raise rates due to rising inflation stemming from the fasten in energy prices. However, the data advise that Europe's economic system is weakening—largely due to the ascent in free energy prices. Meanwhile the ECB also wants to limit the widening in bond spreads between core and peripheral countries as markets focus on recession risks in countries with high debt levels. Talk about a policy dilemma.

Non to exist left out, Banking company of Japan (BOJ) President Haruhiko Kuroda has had to repent repeatedly over the past few weeks for maxim that Japanese consumers don't listen ascent inflation stemming from the yen's steep driblet. The problem is that the BOJ is trying to take information technology all ways. It wants to maintain its zero-interest-rate policy and yield-curve control, while also preventing the yen from falling to a new multi-decade low.

Not surprisingly, markets have been roiled by these disruptive and sometimes round arguments coming from cardinal bankers. Merely in my view, the bail market has it figured out. Since the Fed's last coming together, Treasury yields have fallen across all maturities. In fact, curt-term yields peaked on the first day of the Fed's last meeting, when the federal funds rate was raised by 75 footing points (or three-quarters of a percentage indicate).

The yield curve has flattened since the last FOMC meeting

Chart shows the yield to maturity for Treasury bonds with maturities ranging from three months to 30 years, on June 14 and on June 30. The yield curve flattened between the two dates.

Source: Bloomberg, data every bit of 6/14/2022 and vi/30/2022.

Past performance is no guarantee of future results.

It looks like the Fed'south actions and pledge to bring inflation down accept resonated with the market. If the Fed follows through in hiking rates every bit much as the recent projections indicate, the risk of recession rises. Consequently, bail yields accept been pulling dorsum from recent highs and the yield curve has flattened.

Bloomberg Financial Conditions Alphabetize

Chart shows the Bloomberg U.S. Financial Conditions Index dating back to 2018. The index was minus 1.2 as of June 30, 2022.

Source: Bloomberg. Bloomberg U.S. Fiscal Conditions Index (BFCIUS Alphabetize), daily data as of 6/xxx/2022.

Note: The Bloomberg U.Due south. Financial Weather condition Index tracks the overall level of financial stress in the U.S. money, bail, and equity markets to aid assess the availability and cost of credit. A positive value indicates accommodative fiscal conditions, while a negative value indicates tighter fiscal conditions relative to pre-crisis norms. Y-centrality is truncated at -2.0 for scaling purposes. For reference, the depression occurred on three/24/2020 and was -6.33. The Z-Score indicates the number of standard deviations by which current financial conditions deviate from the boilerplate. A positive value indicates accommodative financial weather, while a negative value indicates tighter financial weather.

The case for lower bond yields in the second one-half of the year

Economic growth is slowing

Gross domestic product (GDP) growth contracted in the starting time quarter, driven primarily by a drop in consumption. Since consumer spending comprises about lxx% of GDP growth, a slowdown in spending is concerning. Early indications point to a risk that Q2 GDP growth was besides likely weak. Two negative quarters of GDP growth isn't the official definition of recession, merely it signals that the indicators are pointing in that direction.

In improver to weaker consumer spending, housing and manufacturing action have slowed in recent months. Notably, the softening in demand is coinciding with increasing supply. Housing inventories are increasing, and houses are sitting on the market longer equally affordability drops. Purchasing director index (PMI) data points to slowing momentum in both manufacturing and services.

PMI for both manufacturing and services activeness has softened

Chart shows Institute for Supply Management manufacturing and services PMI dating back to 2019. As of June 30, 2022, both indices were just above the 50 marker that separates expansion and contraction.

Source: Bloomberg.

U.Southward. Manufacturing PMI SA (MPMIUSMA Index) and U.S. Services PMI Business Activity SA (MPMIUSSA Index). Monthly data equally of 6/thirty/2022.

In the manufacturing sector, the difference between new orders and inventories is negative—something that usually coincides with a drop in GDP growth. Ascension inventories relative to slowing demand suggest that inflation pressure stemming from shortages of goods should ease.

The difference between new orders and inventories is negative

Chart shows ISM new orders minus ISM inventories, as well as quarterly annualized GDP growth since 2018. ISM new orders minus ISM inventories has declined during the past year, at the same time that quarterly annualized GDP also has fallen.

Source: Bloomberg.

GDP US Chained 2012 Dollars YoY SA (Gdp CYOY Index). Quarterly data equally of Q2 2022. Institute for Supply Management (ISM) Manufacturing New Orders (NAPMNEWO Index) - ISM Manufacturing Inventories (NAPMINV Index). Monthly as of 5/31/2022.

The labor market, which is a lagging indicator for the economy, is also showing signs that hiring momentum is slipping. Initial jobless claims have been ascent since the second quarter, and the four-week moving average reached its highest level since January. Despite the repeated concern expressed by Fed officials that the labor market place is strong—even "also potent"—the high-frequency data suggest it is softening.

The four-week moving boilerplate of jobless claims has ticked upward

Chart shows the 4-week moving average of initial jobless claims. Initial claims have risen in during the past two months.

Source: Bloomberg.

Us. Employment and Preparation Administration. Weekly Initial Jobless Claims (INJCJC Alphabetize) and Standing Claims (INJCSP Index). Data as of half dozen/thirty/2022.

Inflation expectations have declined

One reason the Fed has given for an aggressive pace of tightening is the fearfulness that inflation expectations will become "unanchored" and therefore cocky-fulfilling. If consumers and businesses believe prices will be higher in the future, they may pull forward consumption and drive demand even higher relative to supply. Moreover, workers may need higher wages to keep up with inflation, causing a "wage-cost spiral." It was the reason cited by Powell for the 75-basis-point rate hike at the last FOMC meeting.

However, market place-based readings of inflation expectations peaked at just over 3% in April and have fallen back since so. The implied 10-year average aggrandizement derived from the TIPS market place fell to every bit low as 2.three% in early July (July 5, 2022) despite current aggrandizement of more than 8%. Information technology's estimated that the Fed's "condolement zone" is for aggrandizement expectations in the 2.0% to 2.5% range.

Inflation expectations discounted in TIPS market have fallen

Chart shows 10-year breakeven inflation expectations. As of June 30, 2022, markets were expecting inflation of 2.5% ten years in the future.

Source: Bloomberg.

U.S. Breakeven ten Year (USGGBE10 Alphabetize). Daily data as of half dozen/30/2022.

Falling commodity prices

Over the past few months, prices in many commodity groups have dropped—from copper and other industrial metals to grains and even oil. After a surge in prices equally the global economy emerged from the pandemic, prices accept begun to drop back, signaling slower goods aggrandizement going forward.

Copper prices take declined

Chart shows copper futures prices dating back to 2017. As of June 30, 2022, the copper price was $371 per pound.

Source: Bloomberg. Copper Future Sep22 (HGU2 Comdty). Daily data equally of half dozen/30/2022.

For illustrative purposes only. Past operation is no guarantee of future results.

Since much of the increment in aggrandizement over the last year can be attributed to the shortage of the supply of goods relative to demand, the recent driblet in prices suggests less inflation in the pipeline.

Quantitative tightening will drain liquidity from the financial system

It hasn't been front end and center in the news lately, only the Fed has begun to allow its residuum sheet to turn down. This will contribute to the tightening in financial conditions. As the Fed allows bonds to mature and "curlicue off" its balance sheet, it tends to shrink the amount of money available in the financial system. As a result, the monetary base—the total corporeality of coin in circulation—declines. In that fashion, a declining residual canvas has the same effect as rate increases. Economists judge that quantitative tightening (QT) probably will be equivalent to 100 basis points¹in tightening or more, depending on how far it extends.

Recently, the growth rate in money supply has begun dropping sharply after rising sharply from the pandemic lows. The current year/twelvemonth growth rate in M2 money supplyⁱⁱ is 6.half dozen%, near the average of the 2014-2019 period. In real terms—that is, adjusted for inflation—money supply growth is negative—consistent with tight monetary policy.

Real coin supply growth is negative

Chart shows M2 money supply and real M2 money supply dating back to 1962. Real money supply growth was negative as of May 31, 2022.

Source: Federal Reserve Bank of St. Louis.

Existent M2 Coin Stock and M2, Per centum Modify from Year Ago, Monthly, Seasonally Adjusted. Monthly data as of 5/31/2022. Shading represents past recessions.

Note: M2 is a measure of the money supply that includes cash, checking deposits, and easily-convertible near coin. M2 is closely watched as an indicator of money supply and future inflation, and every bit a target of central bank monetary policy. Existent M2 Money Stock Series deflates M2 money stock with CPI.

How depression tin they go?

With headline aggrandizement all the same high, it may exist hard for bond yields to fall much below 2.75% in the well-nigh term. However, it also appears that the iii.5% level reached in June could marking the high for the year. If recent economic trends keep, it would not exist surprising to see 10-year Treasury yields fall further in the second one-half of the year, perhaps every bit low as two.5%. That may prompt the Fed to ho-hum its step of charge per unit hikes and/or change its tightening plan later in the yr. However, it may seem counterintuitive, only the more the Fed "front loads" its rate hikes and runs the adventure of triggering a recession, the lower bond yields can fall.

We suggest investors looking to add more yield to their portfolios consider adding more duration—exposure to interest rate adventure—to their portfolios with bonds that have low credit risk, such as Treasuries and investment-grade corporate and municipal bonds. A bond ladder strategy tin can exist an effective fashion to average into the marketplace.

10-year Treasury yields may have peaked in June

Chart show the 10-year Treasury yield dating back to 2018. It recently rose to 3.5%.

Source: Bloomberg.

U.S. Generic ten-year Treasury Yield (USGG10YR INDEX). Daily data every bit of 6/xxx/2022. Past operation is no guarantee of hereafter results.

¹One basis signal is equal to 1/100th of 1%, or 0.01%, or 0.0001.

² M2 is a measure of the money supply that includes cash, checking deposits, and easily-convertible near coin.

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