Even as the Federal Reserve went ahead this month with the year’s second quarter-point hike in policy rate, the rally in long-term Treasuries refuses to budge. So much so that yields are hitting record lows. Are investors skeptical about the U.S. economy’s readiness for monetary tightening?
On June 14th, the target range of the Fed funds rate – which banks charge each other for overnight lending – increased to 1-1.25%, in its fourth post-crisis hike since December 2015. Yields on 10-year Treasuries dropped to the year’s lowest at 2.15% that day, before settling at 2.16% by the week’s end. Is the Fed’s move to keep inflation in check turning out to be too much of a good thing?
Are Fizzling Inflation Expectations Pushing Down Treasury Yields?
Lower expected inflation theoretically leads to demand for lower yields, which is reflected in the present bond rally. Also, until there is better clarity on fiscal policies, many investors could be seeking the “safety” of fixed-income, thereby keeping down Treasury yields.
Donald Trump’s pro-growth promises supercharged investor optimism on economic growth and inflation, leading to Treasury yields soaring in the weeks immediately following the November election. But, between a policy proposal and its implementation, there often hangs a fuzzy timeline – a reality that is increasingly sinking in and potentially tempering post-election euphoria. With Trump’s proposed tax overhaul shrouded in uncertainties, and details on the trillion-dollar infrastructure project still pending, investors are probably on a “wait-and-see” mode for fiscal stimulus expectations as of right now.
The actual inflation figures are not helping to change this either. The year-over-year Core PCE Inflation (i.e. excluding food and energy) has remained below the Fed’s target of 2% every month this year. In April, it was 1.5%, having declined after February. Wage growth is still sluggish – contributing to slow job gains. The Fed’s monetary tightening amid the less-than-phenomenal price and wage growth rates and uncertainties around fiscal stimulus are possibly toning down the inflation outlook for investors.
Is the Tightening Well-Timed?
In a bid to rein in chances of overheating, many may be wondering if the Fed is getting too ahead for the economy’s good? While the policy rate hike is lifting yields of short-term maturities, the rally in long-term Treasuries is pushing down the latter-end of the Treasury yield curve. The spread between two-and-30-year Treasuries has dropped to a record low of 137 basis points as of this writing. The flattening of the yield curve often sparks slowdown concerns since many recessions followed a negatively-sloped curve.
But this time, the yield curve flattening is far from portending a downturn yet. After almost a decade of near-zero short-term interest rates intended to extricate the U.S. economy from a recession, the Fed is finally ‘normalizing’ rates on the back of an apparent ‘full employment’ in the nation. The tightening has moved up the interbank overnight rate to 1% this year – for the first time in almost nine years. If the Fed didn’t raise rates yet, it would not have enough room to lower them for stimulating the economy if the need arises in future.
Moreover, despite its drag in recent months, inflation may be inching up closer to the Fed’s target cap of 2% by the year’s end. According to Zacks Research, the Core PCE Inflation is projected to hit 2% in 2017 and touch the same level by next year’s end as well (per May 2017 Economic Outlook). Also, wage growth is expected to pick up soon, given recent evidence of a skills gap that employers are facing while hiring.
Bottom Line for Investors
The Fed’s improving optimism on the economy led to its policy rate hike last week. But, investors may still be wary of government policy uncertainties, and many of them have probably become less confident about inflation – leading to low Treasury yields and a flatter yield curve. Nevertheless, the fundamentals are way too healthy to warrant an economy-wide downturn, at least for the near-term. Plus, the yield curve is still upward sloping.
What’s more, the upward momentum in bond prices is not without a concomitant rally in equity markets – proving that fundamentals hold their own even amid ‘noisy’ headlines or policy uncertainties. Corporate earnings registered a solid performance in recent quarters, and the outlook for the coming quarters is sanguine as well.
In all, irrespective of policies and politics, it is fundamentals that will stand the test of time in guiding a financial security’s potential. That’s why, at Zacks Investment Management, we build a fundamentals-based investment discipline customized for each client’s financial needs. By leveraging unbiased research and in-house tools, we guide our clients on every detail affecting fundamentals. If you need help in understanding which investment strategies suit your investing needs, risk tolerance and time horizon, give us a call at 1-888-600-2783.
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