The Economy and Bond Market Radar (June 9, 2014)

The Economy and Bond Market Radar (June 9, 2014)

After falling roughly 20 basis points in May, 10-year Treasury bond yields reversed course this week and rocketed higher. Mid-week last week, the 10-year Treasury yield touched 2.40 percent intraday but analysts and market watchers were having trouble explaining why. In classic financial market fashion, yields moved sharply higher this week, not only reversing last week’s move, but moving even higher. The key stories were the ISM manufacturing index posted solid results, nonfarm payrolls were in-line with expectations, and the European Central Bank (ECB) eased as expected but also gave the market more unconventional easing measures that exceeded expectations. It is hard to ascribe the move in bond yields to fundamental data, so the best explanation appears to be the market pendulum swung too hard on the way down and just reversed that this week.

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Strengths

• The ECB delivered the interest rate cut the market was looking for and more. The ECB cut the rate on excess reserves held by banks at the central bank to negative 10 basis points to incentivize banks to lend those reserves. The ECB also implemented unconventional easing measures designed to spur non-mortgage lending by facilitating cheap long-term financing for banks.
• The ISM Manufacturing index rose to 55.4 from 54.9 in May, which is a level consistent with solid economic growth.
• Nonfarm payrolls grew 217,000 in May and met market expectations. While not a blow-out report, the economy does consistently grind out about 200,000 jobs per month and shows steady, incremental economic improvement.

Weaknesses

• Construction spending in April rose 0.2 percent but was less than expected.
• The U.S. trade deficit hit a two-year high in April, even as domestic oil production has increased substantially.
• Eurozone inflation hit a five-year low, rising 0.5 percent year-over-year. Europe is dangerously close to deflation and it is possible the ECB took too long to act.

Opportunities

• Retail sales for May will be released next week, and bodes well for a strong report, with consumer credit expanding and early indicators pointing toward good growth for retailers that have already released information.
• With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields is likely down.
• There are many moving parts to the taper decision and while the Fed began the process it is very possible that tapering could be delayed if the economy stumbles

Threats

• Long-term bonds have posted strong returns so far year to date and with economic data looking supportive a modest sell off wouldn’t be surprising.
• While the ECB is moving toward easing, U.K. policymakers at the Bank of England are considering raising interest rates as the housing market has been very strong along with retail sales.
• Housing data remains mixed and the spring selling season has disappointed so far. If activity doesn’t pick up soon, housing may not be the positive catalyst many were expecting for 2014.