Updated: 06-23-2017

U.S. Treasuries traded higher at most maturities this week but the Fed's persistent tightening in the face of sluggish inflation data pushed the 2-year note price lower. The end result was a dramatic flattening of the yield curve. While the core producer price index did beat forecasts in May with 0.3% m/m growth, both the headline and core consumer price indices came up short. Fed policymakers and other macroeconomists generally tend to view the unemployment rate and the inflation rate as having an inverse relationship, famously depicted in the Phillips Curve. With the unemployment rate falling to 4.3% in May and the core CPI up just 1.7% y/y, there is a fair amount of hand-wringing happening among the doves on the Federal Open Market Committee. While most policymakers are still on board with a gradual path of rate hikes, Minneapolis Fed President Neel Kashkari dissented in Wednesday's 8-1 FOMC decision to hike the target range for the fed funds rate by 25 basis points to 1.00-1.25%. Then on Friday, Dallas Fed President Kaplan (FOMC voter) said that "[the FOMC] should be very careful about raising rates and we should do it patiently and carefully."

Kashkari and Kaplan may find some sympathy in the second half of 2017 from Fed Governor Brainard. She said on May 30 that, "If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today." Chicago Fed President Charles Evans (FOMC voter) is also concerned about the Fed's persistent undershooting of its 2% target for core PCE inflation. He said on May 24, "I believe demonstrating a strong commitment to our objectives by trying harder to hit our symmetric inflation objective sooner rather than later is key to actually achieving this goal."

In short, the combination of persistently weak inflation and continued asset purchase programs at the European Central Bank and the Bank of Japan are keeping long rates low while the Fed is slowly but steadily hiking rates. These two countervailing forces are flattening the yield curve.

In related markets, the S&P 500 was mostly unchanged at 2,433.2 and WTI crude lost $0.86 to $44.97/bbl.

6/16/2017 6/9/2017 Change
Fed Fund Futures Rate Prediction June 2018 (59%) June 2017 (73%)  NA
10yr Treasury - 2yr Treasury 84 bps 92 bps  -8 bps
High Yield - 10yr Treasury 384 bps 394 bps  -10 bps
Corp A - 10 yr Treasury 102 bps 106 bps  -4 bps
10 yr Bund - 10 yr Treasury -182 bps -189 bps  7 bps
5yr, 5yr Forward Inflation Breakeven 1.77% 1.87% -10 bps

The yield spread between the 10-yr Treasury note and the 2-yr Treasury note fell by 8 basis points to 84 bps. The FOMC voted 8-1 on Wednesday to raise its target range for the federal funds rate by 25 basis points to 1.00-1.25% and showed little sign of concern about the recent shortfalls in inflation indicators. Weak retail sales and housing starts data helped keep a lid on longer-term Treasury yields.

The yield premium on high-yield debt narrowed by ten basis points to 384 bps over Treasuries of comparable maturities. Junk bond spreads have been quite tame lately and are priced for low default rates and high recovery ratios. Prices rebounded and yields declined through the middle of 2016 as oil prices recovered from their lows, but high-yield bonds have been mostly unchanged this year, despite oil prices grinding lower.

Investment-grade spreads narrowed by four basis points to 106 basis points.

The 10-yr German bund yield rose by seven basis points relative to the 10-yr Treasury yield, ending at 182 basis points below the U.S. government security's yield. Eurozone economic growth continues to look strong and public sentiment for European institutions appears to have steadied or improved since the U.S. election in November 2016.

Market expectations for five-year, five-year forward inflation fell to 1.77% from 1.87%. May's data for both consumer and producer prices is showing that even 4.3% unemployment is not enough to get inflation back to the Fed's target. The Fed has been undershooting its 2% target for core PCE inflation for many years now.

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