The Outlook for Yields

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global investingGlobal CIO Commentary by Scott Minerd of Guggenheim Partners – July 03, 2014

As U.S. economic growth gathers pace, yields on 10-year U.S. Treasuries should shift higher over the next two-three years, eventually moving as high as 3.25 – 4 percent.

While a broad-based secular increase in inflation will be a problem that comes most likely in the next decade, a number of technical and cyclical forces, such as healthcare and shelter costs, are working to push consumer prices higher over the next six months or so.

However, these forces are unlikely to spark sustained inflation in the near term, given that the U.S. unemployment rate is still quite high, the labor force participation rate has been on a downward trend for a number of years, and capacity utilization is still significantly lower than the threshold associated with a broad increase in consumer prices. In the medium-term, wage pressure will continue to rise and aggregate demand should improve. Rather than being the harbinger of an inflationary spiral many investors fear, that should be positive for economic activity.

Our research suggests that the yield on the U.S. 10-year Treasury bond should now be 3-3.25 percent, yet yields have been hovering around 2.6 percent. Keeping rates low in the near term are technical factors such as central bank accommodation flooding global markets with liquidity and some form of quantitative easing likely coming in Europe.

This week’s ADP report showing U.S. firms added 281,000 jobs in June, the most since November 2012, is the latest sign that the U.S. economic recovery is picking up steam. Over the next two to three years, given that economic growth is likely to be stronger, unemployment is likely to be lower, and inflation is likely to be higher, we will eventually start seeing fundamentals take over, resulting in higher yields on U.S. Treasuries. Assuming the U.S. Federal Reserve starts raising interest rates mid to late next year, we could see the U.S. 10-year Treasury bond reaching a cyclical high of somewhere around 3.75-4 percent.

U.S. Wage Pressure Approaching, But Not Here Yet

An improving labor market, brighter growth prospects, and higher capacity utilization are pointing to a U.S. economy approaching equilibrium. Historically, once the economy moves past equilibrium, whether defined by unemployment, output, or capacity, significant wage inflation tends to follow. Though we are drawing nearer to these levels, it is likely to take one year or longer before the gap is closed and broad-based wage inflation emerges.

Source: Haver, Guggenheim Investments. Data as of 7/2/2014. Note: We define the output gap using Congressional Budget Office (CBO) data on potential GDP, where the gap is the difference between actual and potential GDP as a percentage of potential GDP. We define the capacity utilization gap in the same way, using 82 percent as the natural rate. We define the unemployment gap using CBO data estimates of the natural rate of unemployment.

U.S. Data Points to Strong Second Quarter

• The ISM manufacturing index cooled slightly in June but remained well in expansion territory, inching down to 55.3 from 55.4.
• Personal Consumption Expenditures (PCE) rose less than expected in May, up 0.2 percent after April’s flat reading.
• The University of Michigan consumer confidence increased in June to the highest level this year, to 82.5 from 81.9.
• Pending home sales increased in May for a third consecutive month, rising by 6.1 percent from a month earlier, making it the best month in over four years.
• Construction spending rose for a second month in May but was below expectations, rising just 0.1 percent from April.
• Initial jobless claims inched down by 2,000 for the week ended June 21, to 314,000.
• Factory orders fell by 0.5 percent in May after rising during the previous three months.
• The core PCE deflator, the Fed’s preferred measure of inflation, rose in May for a third straight month, to 1.5 percent — the highest since January 2013.

China Manufacturing Positive, European Prices Muted

• Euro zone consumer prices rose 0.5 percent year over year in June, equaling May’s gain.
• Euro zone economic confidence unexpectedly declined in June to 102.0 from 102.6.
• Retail sales in Germany unexpectedly fell for a second consecutive month in May, decreasing 0.6 percent.
• Germany’s CPI accelerated to 1.0 percent year over year in June, the highest in four months.
• Spain’s manufacturing PMI rose to 54.6 in June, a seven-year high.
• The manufacturing PMI in the United Kingdom expanded to 57.5 in June, the best level this year.
• China’s official manufacturing PMI showed a faster pace of expansion for a fourth straight month in June, rising to 51.0.
• Japan’s Tankan survey of large manufacturers dropped to 12 from 17 in the second quarter. The outlook index, however, reached its highest level since 2007.
• Japan’s industrial production showed a small rebound in May, rising 0.5 percent after a 2.8 percent drop.
• Japan’s CPI climbed higher in May to 3.7 percent year over year, reflecting the recent sales tax hike. Core prices rose 3.4 percent, the highest since 1982.

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