Train Spotting

My first boss told me something years ago about the bond market that I’ll never forget. He said, “never stand in front of a moving train.” I think about it every time I trade. He meant that if interest rates (the train) start to move quickly in one direction and get out of control – just step aside or you’ll get run over. We aren’t quite there yet in today’s U.S. Treasury market, but it looks as though the coal is being loaded!

The lengthy economic expansion that began in the summer of 2009 has accelerated in 2018. Thanks to the twin turbos of tax reform and deregulation, we’re now well into our tenth year of growth, and just a couple quarters away from marking the longest U.S. economic upturn since 1900. In 2018, real U.S. Gross Domestic Product (GDP) is likely to grow more than 3 percent for a full calendar year for the first time since 2005. Job growth is accelerating, and consumer sentiment is near all-time highs.

Unemployment continues to fall, but both wages and inflation have been slow to keep up. As the graph shows, unemployment at 3.9 percent is touching historical lows, but wage growth has remained in the doldrums. This enables the U.S. Federal Reserve (Fed) to continue gradually but steadily raising interest rates. Inflation remains quiescent. Both halves of the Fed’s dual mandate (full employment, low inflation) appear to be well within reach, as employers resist giving workers raises despite looming trade restrictions and government minimum wage mandates.

Given this unadulterated good news, September 2018 could mark the beginning of a long-term upturn for bond yields. Early in 2018, we saw the 10-year U.S. Treasury yield rise to 3.11 percent, but it soon fell back below 3 percent as trade tensions put a jolt of fear in the marketplace. In the summer, good economic news along with reduced negative chatter on trade allowed the yield curve to steepen once again. Long rates rose; the 10-year yield ended the third quarter at 3.09 percent.

The Federal Reserve Open Market Committee raised short term interest rates again in September, and stated they are likely to continue hiking in a controlled manner. The Fed funds future market is now anticipating one more increase in December 2018, and two increases in 2019. Next year at this time, we could have a 3 percent overnight lending rate, and a 10-year Treasury yield above 4 percent. Although still below historical averages, interest rates at these levels would be welcomed by savers and people that rely on fixed income investments.

One person decidedly against higher rates is President Donald Trump. Fed Chairman Jay Powell is determined to “normalize” interest rates (whatever that means) despite howls of protest from the President. The robust U.S. economy has given Powell cover in the form of a steady drumbeat of positive news on growth, jobs and inflation. Only time will tell if he can withstand the broadsides of our Commander in Tweet!

The era of zero interest rates is now over. Going forward, we must obviously stay keenly aware of where rates are headed. After the third quarter ended, the 10 year Treasury yield approached 3.25 percent for the first time in a decade. This is notable because many consumer loans are priced off the 10-year Treasury. Mortgage rates are just one example. A steady rise in mortgage rates in 2018 has markedly cooled housing demand, and this weakness could easily spill over into the rest of the big-ticket consumer economy. One of the quickest ways to flatten an economy is with an uncontrolled spike in long-term borrowing rates. We aren’t there yet, but we’ve got our ears to the rail!

Nathan Boxx, Bradley Newman, Jason Seltzer

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