The Market Today
Fed Gaining Confidence; Markets Losing Confidence; Economy Continues Sluggish Productivity Gains
by Craig Dismuke, Dudley Carter
Productivity Continues Its Disappointingly Slow Grind: In a very disappointing report, nonfarm productivity actually declined in 4Q based on the preliminary estimate. While this did push unit labor costs (the cost of producing one unit of goods/services) up 2.0%, well above the expected 0.9% gain. However, the continuation of weak productivity is the longer term challenge. Productivity has now averaged a rate of just 1.1% during this cycle. Productivity is the key to sustainable economic improvement, particularly given the weak growth in the labor force. Initial jobless claims fell from 231k to 230k for the week ending January 27. The hot labor data continues. At 9:00 a.m. CT, the December read on Construction Spending is expected to show a 0.4% increase. Also at 9:00 a.m., January’s ISM Manufacturing index is expected to pull back to a still-strong 58.6. January’s vehicle sales data will be released throughout the day and is expected to show the post-hurricane bump continuing to fade. Despite the full calendar today, investors have plenty of other information to continue digesting – Treasury supply (more below), the FOMC Statement (more below), and tomorrow’s BLS jobs data.
Yesterday’s Trading Activity – Stocks Rose and the Curve Flattened after the Fed Reported an Optimistic Outlook in Yellen’s Final Meeting: U.S. stocks erased early gains after the Fed reported an optimistic outlook that bolstered the market’s expectation for another rate increase in March. However, a late-afternoon recovery helped the major indices back above Tuesday’s close for their first positive finish of the week. Treasury yields had climbed higher ahead of the Fed decision but fared differently for the remainder of the session. The entire curve shifted higher after the Fed’s Statement highlighted solid growth and an expectation for inflation to move up this year but trimmed those gains to different degrees in the last several hours. The 2-year yield moved back to its pre-meeting level which was enough to add another 1.6 bps and lift the yield to 2.14%, another cycle-high. The 5-year yield fell below its lunchtime level but rose 0.8 bps on the day to 2.51%. The 10-year yield faded even further, dropping 1.5 bps to 2.71%. With Tuesday representing the last day of the month, some traders indicated month-end rebalancing flows may have added to the flattening of the yield curve.
Overnight Activity – Yield Climb Continues: Equities were mixed across Asia and strong early gains in Europe have been erased halfway through Thursday’s session. Equities continue to keep a watchful eye on climbing global yields which have pushed several major sovereign curves to their highest levels in years (read more about that here). In front of a busy economic calendar, that climb has continued. Longer U.S. yields have reversed yesterday’s afternoon decline and are leading a global rise on Thursday. With month-end rebalancing support out of the way, the 10-year yield is up 3.2 bps at 2.74%, a new high since April 2014, after earlier touching 2.75% for a second day. The 5-year yield is up 2.2 bps to 2.54% representing a new high since April 2010. As has become almost expected, the 2-year yield is up to a new cycle high of 2.16%. Since September 8, the 2-year yield has risen in 70% of trading days (73 of 105) as the market has increasingly priced in the likelihood the Fed’s projection of three rate hikes this year will become a reality (more on the Fed below). It’s a similar story in Europe with the German 10-year yield up 1.8 bps to 0.72%, its highest level since September 2015. The Dollar popped briefly but reversed to make a new more-than-three-year low. The Euro is stronger after the region’s Markit Manufacturing Index matched expectations in January at 59.6 and, despite a slight downtick, remained at one of its best levels on record.
Markets Anxious about Treasury Issuance: The Treasury Borrowing Advisory Committee (TBAC) estimated in a report yesterday that Treasury would need to borrow net $955 billion in FY 2018 (thru September). Additionally, they estimated that Treasury would need to place $1.08 trillion in FY19 and $1.13 trillion in FY20. This marks a dramatic increase from the net $519 billion issued in FY17. Furthermore, with the Fed allowing its balance sheet to shrink, they will no longer be absorbing some of this issuance. As discussed in our 2018 Economic Outlook, the projected $230 billion decrease in Fed absorption and the $418 billion in additional Treasury supply means the markets will have to take in $669 billion more Treasurys this year than last. The increased issuance is the result of markedly lower tax revenues in the wake of the tax reform law. Moreover, the amount could be increased if any material increase in government spending results from an infrastructure spending package (all signs point to something getting done on this).
Fed Sees “Solid” Economic Activity, More Confident on Inflation, Expects to Continue with “Gradual” Hikes: The Federal Reserve voted unanimously to leave its target rate range unchanged at 1.25-1.50% in Janet Yellen’s final meeting as Chairwoman. The Official Statement reflected an improved assessment of economic activity. It read as almost as a victory lap for Chairwoman Yellen, with the economy meeting the objectives of the Fed with one exception – inflation. However, the description of inflation was improved. The December Statement noted that inflation was expected to “remain somewhat below 2 percent in the near term” before stabilizing around 2 percent in the medium term. The January Statement notes that inflation is now expected to “move up this year,” stabilizing around 2 percent in the medium term. Given the strong assessment of economic activity and confidence that the stabilization of inflation is near, the Statement could be seen as slightly hawkish. However, that is to be expected given the recent performance of the economy and the financial markets. Inflation will continue to be the key to how fast the Fed can hike.