The U.S. Treasury yield curve had an interesting reaction to today’s blockbuster payrolls data. June saw 287,000 U.S. jobs created, more than making up for May’s dismal 38,000 number and leaving the six-month average at 172,000 jobs created per month. Normally one would expect data like today’s to steepen the yield curve with longer rates selling off more than shorter rates as inflation expectations rise and term premium comes back into a yield curve that is too flat by most historical measures. Instead two-year rates have moved higher and 30-year rates have moved lower! In addition to the oft-cited global factors, we feel there are two related reasons for this unusual price action:
- The yield curve is so flat in the first place because the market discounts the Federal Reserve’s desire to reach its inflation target of 2.0% for the PCE index. (Personal Consumption Expenditures is the Fed’s preferred inflation measure; 2.0% PCE corresponds to about 2.35% CPI (Consumer Price Index.)) U.S. inflation has been persistently below target, and yet, since 2013 and the quantitative easing “taper tantrum,” the Fed has been periodically threatening to raise rates, then backing away. As we have repeatedly argued regarding inflation targeting, the Fed needs to be credible in its desire to raise inflation and inflation expectations – otherwise we run the very real risk of the U.S. economy getting into a Japan-like situation in which the Fed tries to raise inflation expectations, even by raising its inflation target, and people just ignore it.
- The Fed’s periodic hinting at possible hikes followed by no hikes (with one exception) has many market observers believing the Fed has become myopically focused on the vagaries of the stock market, almost to the point where it ignores most other indicators of economic health. So with a strong payroll number today and the S&P 500 modestly higher on the year, people fear the Fed will once again start talking up the likelihood of a rate hike. Most bond market participants agree this would be a hawkish mistake; hence short-term Treasury yields have moved higher, while the 30-year is moving lower.
The Fed should measure U.S. economic success not in terms of a higher stock market, which benefits mostly the wealthy, but in rising wages. One market indicator of this would be a re-steepening of the yield curve as term premiums and inflation expectations move toward normal levels. The futures market anticipates overnight rates for this cycle peaking at 2% or even lower; a healthier environment would have rates peaking at 3% in line with the Fed’s own expectations. Similarly, 30-year inflation expectations (as signaled by the Treasury Inflation-Protected Securities (TIPS) market) above 2.0%, rather than the current 1.6%, would indicate the Fed is regaining its credibility in terms of reaching its target, despite being below that target for most of the last 10 years.
The Fed needs to be clear and consistent on its objectives (and its desire to meet both aspects of its dual job and price stability mandate), rather than reacting to every twist and turn of the stock markets and high frequency data.