Ten-year Treasury yields dropped to 3.38% percent this morning, the lowest level since early September of last year. The Fed funds rate at that time was about to be lifted to 3.25%, while today the rate stands at 4.50% and is expected to be lifted to 4.75% at the FOMC meeting in early February. The catalysts behind the move lower in rates since the beginning of the year have been lower inflation readings that have worked to confirm market sentiment that peak inflation has occurred, along with a consequent slowdown in the expected pace of Fed tightening to 25 basis points in February, with a residual increase or two expected by the July meeting. Futures markets then anticipate rate cutting to commence in the second half of this year. Today’s data points for retail sales and industrial production were quite weak, and if the December pace in sales and production were sustained in the coming months it would be consistent with the onset of a recession. The extreme inversion in the yield curve today implies the fed funds rate is near its peak level and significant rate cutting by the Fed lies ahead over an intermediate term horizon.
The fundamentals as they appear today suggest that long term Treasury yields have probably gotten a bit ahead of themselves. The labor market remains extremely tight, which implies that wage pressure is likely to remain persistent until unemployment moves higher. The decline in long term yields since the start of the year has also led mortgage rates lower, and we saw a large jump in mortgage demand for home purchases over the past week in response to the drop in mortgage rates. Homebuilder sentiment also moved higher in January. That is counterproductive to the Fed’s policy that is designed to reduce demand for interest sensitive spending. There has also broadly been a dash for last year’s trash in the financial markets early this year, led by stocks with the highest short interest and some of last year’s biggest decliners such as Bitcoin and Tesla. Equity markets are up solidly in the first weeks of the year and credit spreads have also tightened and are at levels that are not consistent with an upcoming recession, in contrast to the yield curve signal. This easing of financial conditions runs counter to the Fed’s goal of reducing demand to a sustainable, noninflationary level. These financial and mortgage market conditions are likely to be countered by at least more hawkish Fed rhetoric in the near term, and potentially more aggressive tightening if they persist.
With yields in the 1-3 month segment of the yield curve averaging a bit above 4.50% today compared to 3.38% for ten-year Treasuries, we are moving some money out of longer maturity Treasuries into the short end of the yield curve. The positioning is based on fundamentals including residual strength in the labor market, and pent-up demand for mortgages and home purchases at today’s long-term yields, and relatively easy conditions in credit markets. These underlying fundamentals are inconsistent with the Fed quickly pivoting to a reversal of its recent rate increases, and absent a Fed that is going to be cutting short term rates, longer term Treasury yields are unjustifiably low today.