Updated: 03-22-2017

U.S. Treasuries made modest gains last week as the FOMC decided to hike rates in a 9-1 decision but the median FOMC participants' forecast for the total number of 2017 rate hikes remained at three. This was interpreted as a dovish hike by market participants and so the very high short position in Treasury futures and eurodollar futures markets left the bears vulnerable to a rally in prices (decline in yields). The sole dissenter in the FOMC's decision to hike the target range for Fed funds to 0.75-1.00% was Minneapolis Fed President Neel Kashkari. He voted to keep rates on hold because, according to an argument that he published later in the week, the economy had not made much progress towards the Fed's dual mandate of full employment and 2% inflation since the January/February FOMC meeting. Furthermore, he argued that the Fed is not acting like the 2% inflation target is a symmetric one.

The U.S. economic data out last week was mostly in line with estimates. Retail sales for February were mostly in line with estimates but January's growth was revised higher. The consumer price index rose in line with expectations (0.1% m/m headline and 0.2% m/m core). The headline producer price index rose 0.3% m/m as did the core PPI, both beating expectations. Housing starts for February beat expectations, driven higher by single-family construction.

In related markets, WTI crude was virtually unchanged at $48.78/bbl. and that certainly helped to support bullish sentiment in Treasuries. Persistent rumors about the sequencing of the European Central Bank's expected monetary tightening campaign helped to drive the euro higher against the U.S. dollar, ending the week at $1.0753. The question in the eurozone is whether the ECB might hike its deposit rate from its current level of -0.40% before eventually tapering asset purchases down to nothing. Markets currently expect that the asset purchase program will be further tapered in 2018 before eventually ending.

3/10/2017 3/3/2017 Change
Fed Fund Futures Rate Prediction June 2017 (51%) March 2017 (52%)  NA
10yr Treasury - 2yr Treasury 117 bps 122 bps  -5 bps
High Yield - 10yr Treasury 373 bps 372 bps  1 bp
Corp A - 10 yr Treasury 104 bps 104 bps  unch
10 yr Bund - 10 yr Treasury -206 bps -216 bps  10 bps
5yr, 5yr Forward Inflation Breakeven 2.12% 2.11%  1 bp

The yield spread between the 10-year Treasury note and the 2-year Treasury note narrowed by five basis points to 117 bps last week. This policy-sensitive part of the curve has been flattening as 10-year note traders have not revised up their expectations for economic growth and inflation to the same extent that the Fed has become more hawkish in its guidance. The 5-year/30-year yield spread, however, hit its narrowest level since 2008 last year as investors see little room for cyclical tailwinds to boost growth while they remain pessimistic about the long-run outlook.

The yield premium on high-yield debt widened by one basis point to 373 bps over Treasuries of comparable maturities last week. The failure of oil prices to rebound from their early-March sell-off is going to challenge the junk bond market the longer it goes on, but producers will probably be able to handle WTI crude in the $40s. Junk bonds have been priced for perfection in recent months. Goldman Sachs plans to launch a junk bond ETF that will eschew the lowest quality borrowers. The two biggest junk bond ETFs by assets are currently JNK and HYG. 

Investment-grade corporate debt yields were unchanged at 104 basis points over Treasuries with comparable maturities last week. Steady oil prices and a stable stock market helped support corporate yields near their narrowest levels since the downturn in oil began in 2014. 

The 10-year German bund yield rose by 10 basis points relative to the 10-year Treasury yield last week to trade 206 bps below the U.S. government security's yield. The first full week of trading after the European Central Bank's March 9 decision was mostly dominated by discussion about the sequencing of the ECB's exit from negative interest-rate policy (NIRP). The question now is whether the central bank will hike its policy rates before ending its asset purchase program. ECB President Draghi has said in the past that this is not a possibility and as long as oil prices remain stable, there is little reason to think that the ECB will have to hike policy rates this year.

The market expectation for five-year, five-year forward inflation rose by one basis point to 2.12%. The Michigan consumer survey for March showed that long-term inflation expectations fell to a record-low of 2.2%. It is not clear how much effect consumer expectations have on realized inflation and the distribution of those expectations is also important. Analysts noted in recent months that the decline in the average expectation for inflation was due mostly to fewer respondents expecting inflation above 5%, a belief that is probably held more intellectually than viscerally. 

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