Updated: 12-05-2016

U.S. Treasuries were mostly unchanged last week as the Thanksgiving holiday subdued trading activity and the economic news flow was relatively light. Durable goods orders jumped by 4.8% m/m in October (Briefing.com consensus 1.1%) and new home sales ran at a 563K seasonally adjusted annual pace (Briefing.com consensus 587K). September's reading was revised down to 574K from 593K. Existing home sales were stronger, however, rising to 5.60 million in October from 5.49 million in September (Briefing.com consensus 5.40 million). The Atlanta Fed's GDPNow model forecast is now at 3.6% for Q4 U.S. real GDP growth. The U.S. economic recovery looks to be gathering speed from the sluggish pace that prevailed for most of 2016. That said, interest rate markets have priced in a lot more growth and inflation in just three weeks' time and so the Treasury complex held its ground.

While stronger current U.S. economic data has been supporting Treasury yields, the big unknowns remain the size and composition of any fiscal stimulus in 2017. The Republican-controlled White House and Congress are expected to enact some combination of tax cuts and infrastructure spending next year. The larger the package and the more oriented toward infrastructure it is, the more it should push nominal interest rates higher. Treasuries have already baked a lot into the cake. 

11/25/2016 11/18/2016 Change
Fed Fund Futures Rate Prediction Dec. 2016 (96%) Dec. 2016 (95%) 9 pts
10yr Treasury - 2yr Treasury 124 bps 127 bps -3 bps
High Yield - 10yr Treasury 441 bps 455 bps -14 bps
Corp A - 10 yr Treasury 112 bps 109 bps  3 bps
10 yr Bund - 10 yr Treasury -212 bps -205 bps -7 bps
5yr, 5yr Forward Inflation Breakeven 2.03% 2.05% -2 bps

The yield spread between the 10-year Treasury note and the 2-year Treasury note narrowed by three basis points this week to 124 bps. Slowing momentum in the long term Treasury sell-off coincided with continued upward pressure on shorter term rates and that is why we now see a narrower 2s/10s spread. The December 14 FOMC meeting is all but guaranteed to hold a 25-basis point rate hike, according to Fed funds futures. 

High-yield debt yields narrowed by 14 basis points this week to 441 bps over Treasuries as stronger momentum in the U.S. recovery and rallying oil prices prompted investors to move out the risk curve. Natural resource producers were some of the most at-risk companies this year and a post-election commodity rally should help improve the terms on which those companies raise money.

Investment-grade corporate debt yields widened by 3 basis points to 112 bps over Treasuries with comparable maturities last week. Corporate spreads are at multi-year lows and investors may be wondering how much narrower they can get before the credit cycle turns.

The 10-year German bund yield fell to 212 basis points beneath the 10-year Treasury yield last week from -205 bps at the end of the previous week. The clouds over the U.S. economic outlook have been receding as the monthly data continue to improve but the Italian constitutional referendum still looms large for the eurozone. The polling right now shows the measure as unlikely to pass and that will jeopardize the Italian banking system's recapitalization efforts. Also, France, Germany, and the Netherlands will have elections in 2017.

Five-year, five-year forward inflation expectations narrowed to 203 bps last week. This is a crucial metric of market-based inflation expectations for Fed policymakers and it has moved up sharply since the November 8 election. Given that the Fed's inflation target is 2%, FOMC members should be pleased with this development.

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