The Consumer Bounces Back in January
Treasury yields have moved to near yearly highs with the usual suspects being inflation fears, improving virus/vaccine outlook, and the coming of Stimulus 3.0. One of the tenets in the improving virus/vaccine outlook is that it will drive a rebound in consumer spending and with two-thirds of the economy based on consumer consumption an improving economy does hinge a lot on said consumer. And to that we received the January retail sales numbers this morning, and they did show vast improvement over the prior three months of negative results when virus cases were soaring and before Stimulus 2.0 checks were received. Overall sales soared 5.3% (MoM) versus a –1.0% drop in December and 1.1% expected. Sales ex autos and gas rose a lofty 6.1% (MoM) versus –2.5% the prior month and 0.8% expected. Finally, the Control Group—a direct feed into GDP—rose 6.0% versus a disappointing –2.4% drop in December and 1.0% expected. The overall sales gain was the largest in seven months. As virus cases and vaccine trends continue to improve, and Stimulus 3.0 checks hit sometime in the next month or two, it’s likely the consumer will add to the numbers posted in January and that could lead to more pressure on Treasuries.
As we mentioned above, Treasury yields have been moving to near one year highs with the 10-Year Treasury pushing over 1.30%. This time last year yields were starting to fall precipitously as the first coronavirus fears were crystallizing. Yields continued lower before bottoming on August 4 with the 10-year yield dipping to 0.51%. Since then, longer maturity yields have grudgingly moved higher while short rates remain locked down by the Fed. That pattern has led to a renewed steepening in the yield curve as the graph below shows. The 2yr-10yr yield spread has moved to a nearly four year high at 118bps.
This steepness in the curve brings with it a host of investment options. For many accounts, it provides a higher yield with which to work from in non-Treasury spread product. Be it MBS, agencies, corporates, and municipals, the higher Treasury yields drag most other sectors along. Also, with the locked down front-end, swapping out of short maturity investments into longer duration bonds has the benefit of allowing investors to take gains on short, lower-yielding assets and reinvest in higher yielding, longer duration bonds that can roll down the curve while the Fed keeps the front-end locked down for a couple more years.
How High Can Longer Maturity Yields Run?
The big question many fixed income investors confront when rates are moving higher is how far will long rates run? The crystal balls are always fuzzy on this but one thing that can be said is that with every basis point higher in yield, foreign investor interest increases given most developed markets still sport negative yields. The graph below depicts the amount of worldwide debt with negative yields in dollar terms. Currently it’s near $16 trillion. That’s off the $18 trillion high in late December but still a much larger amount than almost any other time. That seems to indicate that if Treasury yields stabilize, there is plenty of potential demand from investors sitting on negative yielding debt. Thus, as yields move higher greater foreign buying interest will result.
Also, TIPS inflation breakeven rates reflect a high degree of confidence that inflation will move smartly over 2%, given the levels of monetary and fiscal stimulus expected. That may be so but we couldn’t do that pre-pandemic with 3.5% unemployment so moving there now will be quite the lift, especially with 10 million still unemployed, more than double prior to COVID. We don’t see a long-lasting lift in inflation until wage gains start to build and the number of employed persons increases. Larger and more widespread pay checks will sow the seeds best for more durable inflation. The labor market seems years away from returning to full employment and the wage gains that are necessary for generating that inflation. If the market has overreacted to the possibility of inflation then some consolidation seems inevitable which would be another dent in the higher rate scenario. So, moving to 1.50% on the 10-Year is certainly within reach, but getting to 2% or more will be increasingly difficult anytime soon.
Agency Indications — FNMA / FHLMC Callable Rates
|Maturity (yrs)||2 Year||3 Year||4 Year||5 Year||10 Year||15 Year|
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