FYI | May 30 2014
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
A little while back we wrote that the US yield curve was sounding a warning about the US economic outlook. Longer-term yields have been falling at a faster pace than shorter term yields, as you can see in figure 1. The inverted shape of the yield curve is often considered a sign of deteriorating economic conditions. However, while the disastrous US economic performance in Q1 can be put down to bad weather, the economy has shown signs of life recently, not least in initial jobless claims and durable goods orders.
Bonds ignore good jobs numbers, again…
Bond yields seem out of synch with the economic data. Take figure 2, it shows initial jobless claims alongside 10-year bond yields, going back to 2005. The last time that initial jobless claims were hovering around the 300k mark was 2006-07, back then 10-year Treasury yields were above 5%, more than double where yields are now.
So what are yields so low? Blame the Fed. Bonds don’t seem to be moving with the economy, unless they see something we don’t, and a massive recession is just around the corner. Instead the focus seems to be on a dovish Fed Governor, Janet Yellen, who the market expects to keep rates low for a prolonged period.
Can rates continue to fall? Rather than give a definitive answer one way or the other, we take a look at two scenarios, one where yields could move lower and one where they could push higher.
– Rate could go lower: Falling rates could become self-fulfilling. As we approached 2014 a lot of people were expecting yields, and the dollar, to rally, which didn’t materialise. The fall in yields has been a shock, so some market players have had to play catch up. This could add to downward pressure on yields.
– Rates could move higher: The bond market could be concentrating on the wrong thing, we have said before that core PCE could be ripe to spike higher, as price pressures further up the inflation pipeline, including food prices, start to mount. If this happens then bond yields could move higher. (See figure 3). if we get another 200k+ reading in next week’s US NFP report, surely the market can’t ignore another good month of jobs data?
So what are bond yields telling us?
– Based on the economic fundamentals, particularly the US labour market, bond yields are too low.
– If we get another strong NFP reading, upward pressure on yields could start to build.
– However, if yields stay de-coupled from the economic conditions in the US they could remain low for some time.
– The most important data releases going forward may actually be inflation, not NFPs. PCE data on Friday could be critical for Treasury yields in the short term. CPI on June 17th is also worth watching.
Market impact:
– While yields remain low this could limit dollar upside, so the elusive greenback recovery that looked like it might be taking off earlier this week could come in fits and starts.
– The technical picture: 10-year yields are approaching a critical level of support – the 61.8% Fib retracement of the June – Jan advance at 2.39% (see figure 4). A break below this level could signal further losses for 10-years.
– Low bond yields are also good for stocks, thus while yields remain weak this could help stocks eke out further gains at these lofty levels.
– However, if the bond market is correct, and a US economic disaster is approaching then stocks could come under pressure. Likewise, if bond yields surge higher on the back of a spike in inflation this could spell bad news for equities.
– Overall, when bond yields and economic data don’t synch up, investors should watch out. Eventually they have to match, and it could be a painful, and volatile, process when they do.
Figure 1: The yield curve
The yield curve is pointing downwards, this can be a warning from the bond market that the economic outlook is bleak.
Source: Bloomberg
Figure 2: Yields and initial jobless claims
Claims haven’t been this good since 2006-7, yet yields are less than half of what they were back then…
Source: Bloomberg
Figure 3: Core PCE and bond yields
Core PCE has been moving higher, if it continues to trend upwards it could take bond yields with it, something that I don’t think the market is prepared for.
Source: Bloomberg and FOREX.com
Figure 4: The technical picture for 10-year yields
We are approaching a key support level at 2.39%, a break below this level could signal further downside.
Best Regards,
Kathleen Brooks| Research Director UK EMEA | FOREX.com
d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com
23 College Hill | 3rd Floor | London EC4R 2RT
Now you can follow us on Twitter: http://twitter.com/FOREXcom
Re-published with permission. Views expressed are not by association FNArena's (see our disclaimer).
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.
Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that FOREX.com is not rendering investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. FOREX.com is regulated by the Commodity Futures Trading Commission (CFTC) in the US, by the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investment Commission (ASIC) in Australia, and the Financial Services Agency (FSA) in Japan. Please read Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/about/publications/character-risks.jsp).
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
