Reality Check for Bonds
Doug Nolan
First of all, despite all the pre-Fed meeting focus on weakness and vulnerability, the U.S. economy has a decent head of steam going.
At 254,000, September’s gain in Non-Farm Payrolls blew away estimates (150k).
While manufacturing lost another 7,000 jobs (less than August’s 27k decline), the service sector is booming.
The 202,000 Services-Producing jobs gain was the strongest since May 2023.
From AP: “Restaurants and bars added 69,000 jobs.
Healthcare companies gained 45,000, government agencies 31,000, social assistance employers 27,000 and construction companies 25,000.”
The Unemployment Rate declined to 4.1% – and hasn’t been lower since May.
September Average Hourly Earnings increased 0.4%, beating expectations of 0.3%, while August Average Hourly Earnings were revised up to 0.5% (from 0.4%).
Average Hourly Earnings were 4.0% higher than a year ago – and haven’t been higher since March’s 4.1%.
During the two-decade period 2000 through 2019, annual growth in Average Hourly Earnings averaged 2.5% - with a high of 3.6% during December 2008.
Friday’s strong Non-Farm Payrolls report was not an aberration.
At 8.04 million job openings, Tuesday’s August JOLTS data beat forecasts by 347,000.
Job openings are now slightly ahead of April’s level. At 143,000, ADP’s September job gain was ahead of estimates and the strongest report since June.
Challenger Job Cuts were down month-over-month, while Weekly Unemployment Claims remain at an historically depressed level (225k last week).
“Fed policy works with a lag.” Often repeated, but in need of an update.
Traditionally, Fed policy adjustments (rates and bank reserves) would over time work to either strengthen or weaken bank lending, in the process impacting (on the margin) economic activity and system liquidity.
It would take some time, but Fed policy adjustments would affect general financial conditions.
These days, “Financial conditions work with somewhat of a lag.”
And, most importantly, markets, not our central bank, have the greatest impacts on financial conditions.
The Fed aggressively eased monetary policy on September 18th.
But conditions had remained loose throughout the Fed’s policy tightening cycle – and loosened significantly about a year ago after the Fed signaled to the markets that it had likely concluded its tightening measures.
My point: months of extraordinarily loose financial conditions (including lower market yields and record debt issuance) should now provide a tailwind to economic activity.
The Fed aggressively cutting rates with financial conditions already so loose elevates overheating risks.
October 3 – Bloomberg (Vince Golle):
“US service providers expanded in September at the fastest pace since February 2023, driven by a flurry of orders and stronger business activity.
The Institute for Supply Management’s index of services advanced 3.4 points to 54.9 last month…
The latest figure exceeded all projections…
The group’s new orders gauge jumped 6.4 points, the most since the start of 2023.
Combined with a four-month high in a measure of business activity, which parallels the ISM’s factory output gauge, the data suggest the economy was on solid footing at the end of the third quarter.
The pickup in demand growth also helped to fuel an acceleration in prices paid for materials and services.
The index of costs paid rose to 59.4 last month, the highest since January, from 57.3.”
The services sector is booming, a not all too surprising development considering abundant Credit availability and bubbling financial markets. Pricing pressures are persistent.
It’s worth noting that money market fund assets rose another $39 billion the past week.
Money market fund assets have surged $329 billion, or 31% annualized, over the past nine weeks – to a record $6.463 TN.
The ongoing inflation of money fund deposits is nothing short of monumental.
When it comes to the ongoing extraordinary growth in money market funds, repos and the “basis trade,” it’s radio silence from the Federal Reserve.
For now, it seems only the unemployment rate matters.
This week, the Bank of England said the quiet part out loud.
October 2 – Financial Times (Martin Arnold):
“The Bank of England has warned of rising ‘vulnerabilities’ in the financial system stemming from increased bets by hedge funds against US government bonds, which reached a record high of $1tn in recent months.
The BoE said… that if hedge funds unwound these ‘short’ positions it would have ‘the potential to amplify the transmission of a future stress’.
These short bets are often part of so-called basis trades, where hedge funds aim to profit from small discrepancies between prices of US Treasuries and futures contracts linked to them.
A period of volatility in global financial markets in August ‘illustrates the potential vulnerabilities in market-based finance to amplify shocks’, the BoE said in a report…
The… ‘the current period of elevated geopolitical risk and uncertainty… could place further pressure on sovereign debt levels and borrowing costs’…
The net short positioning of hedge funds in US Treasury futures markets hit a new high of $1tn in recent months, up from a previous peak of $875bn.
‘Relative to the size of the US treasury market, this was larger than the previous high reached in 2019…’
A rapid deleveraging of these short positions could be triggered by a number of factors, including ‘if repo market functioning were to deteriorate materially; if counterparty credit risk were to increase; or if investors in the basis trade were to take losses on their positions’.”
Ten-year Treasury yields jumped 22 bps this week, with yields rising to an almost two-month high.
Two-year yields surged 36 bps to 3.92%, and benchmark MBS yields rose 34 bps to 5.22%.
The market ended the week pricing a 4.28% Fed funds rate at the Fed’s December 18th meeting, up 22 bps this week.
This implies 55 bps of rate reduction by year end.
For the end of 2025, the market is pricing a 3.29% fed funds rate – up a notable 44 bps this week.
This implies 154 bps of rate reduction by the end of 2025.
Crude prices surged 9.1% this week to $74.38.
After reaching almost $85 a barrel in early July, crude traded down to $65 in early September, before closing the quarter at about $68.
The Bloomberg Commodities Index rose to 107.54 in May, before reversing sharply lower to close September 10th at 93.33.
Since then, the Bloomberg commodities index has rallied almost 9% to 102.08.
Crude closed the week at a six-week high.
The help weak energy and commodities prices were providing on the inflation front may have run its course.
Fortunately, it appears the East Coast longshoreman’s strike has been resolved for now.
But there are other developments pointing to upward pricing pressures.
Bloomberg:
“Global Food Prices Risk Spiking on Worst-Ever Drought in Brazil.”
WSJ:
“Food Prices Rose at Fastest Rate in 18 Months in September, UN Says.”
And we should give significant weight to China’s recent “whatever it takes” moment when pondering inflation risk.
Until proven otherwise, Beijing seems hell-bent on reflation.
Talk of possible Israeli strikes on Iranian oil infrastructure had the crude market in somewhat of a tizzy.
And seeing Hurricane Helene’s incredible destruction reminds me of how much spending these massive storms will spur for both reconstruction and preventative measures.
It looks like a stretch to believe the current backdrop is conducive to consumer inflation stabilizing back down at the Fed’s 2% target.
October 2 – Reuters (Howard Schneider):
“The U.S. central bank’s fight to return inflation to its 2% target may take longer than expected to complete and limit how far interest rates can be cut, Richmond Federal Reserve President Thomas Barkin said…
Barkin said he supported the half-percentage-point rate cut the Fed approved last month…
But he said he was concerned inflation could prove sticky next year and prevent the Fed from cutting rates as far as investors and some of his colleagues expect…
Beyond the next few months and into the second half of 2025, ‘I'm more concerned about inflation than I am about the labor market,’ Barkin said, with a combination of continued solid demand and renewed tightness in the labor market making it hard for the Fed to travel the ‘last mile’ in lowering inflation.’”
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