The Treasury bond market was stunned by the drop in the Federal Open Market Committee’s “dot chart” projection for year-end 2019 fed funds’ midpoint from the 2.875% of December 2018’s projection to 2.375% as of March 2019’s projection. Moreover, the FOMC formally announced that the passive reduction of its bond holdings would end in September 2019.
In response, the probability of a December 2019 Fed rate cut rose to 39% on March 21. At the same time, the 10-year Treasury yield fell to 2.52% for its lowest reading since early January 2018.
Despite a less restrictive monetary policy, earnings-sensitive securities may have difficulty climbing higher until the market is convinced that an extended contraction by profits does not impend. A rejuvenation of core business sales would lessen the risks now surrounding the earnings outlook.
January 2019’s core sales, which exclude sales of identifiable energy products, sank by 0.4% monthly for U.S. manufacturers, but rose by 0.4% for retailers. For now, core business sales are expected to grow by 3.2% year over year during 2019’s first quarter, slower than the yearly increases of 3.4% for 2018’s final quarter and the much livelier 5.5% and 5.6% readings for 2018’s third and second quarters.
The FactSet consensus now expects S&P 500 earnings per share to fall by 3.6% annually in 2019’s first quarter as the year-over-year growth of S&P 500 revenues decelerates from calendar-year 2018’s 8.8% to a projected 4.9% in 2019’s first quarter. Not since 2016’s second quarter have S&P 500 earnings per share declined from the year earlier pace.
Treasury Yield Shows a Paradoxical Inverse Correlation with Federal Debt-to-GDP Ratio
As derived from the Federal Reserve’s “Financial Accounts of the United States,” fourth-quarter 2018’s $17.865 trillion of outstanding U.S. government debt approximated 87.1% of yearlong 2018’s nominal GDP. Despite how this ratio is up considerably from the 42.0% of 2007’s final quarter, a recent 10-year
U.S. Treasury yield of 2.55% is well under its 4.10% average of December 2007.
All else the same, a higher ratio of federal debt to GDP implies higher Treasury bond yields than otherwise. However, all else is never the same. The ratio of federal debt to GDP is one of many variables that determine Treasury bond yields.
Intuitively, the 10-year Treasury yield is expected to show a positive correlation with the ratio of federal debt to GDP. Here, theory is seemingly upended, and instead the 10-year Treasury yield shows an inverse and significant correlation of -0.67 with the ratio of U.S. government debt to GDP for a sample that starts with 1985’s final quarter.
Over time, many forecasters have been fooled by the 10-year Treasury yield’s tendency to fall as the ratio of federal debt to GDP climbs higher. Nevertheless, it would be mistake of the highest order to claim that an increase in the ratio of U.S. government debt to GDP will reduce Treasury bond yields.
Treasury Yield’s Strong Correlation with Fed Funds Comes with an Important Exception
In line with expectations, the 10-year Treasury yield generates relatively strong positive correlations of 0.90 with the federal funds rate and 0.79 with the annual rate of core PCE price index inflation. Of course, the reality of inverted yield curves reminds us that the 10-year Treasury yield does not always move in the direction taken by the federal funds rate. In fact, since fed funds was last hiked on December 19, 2018 to 2.375%, the 10-year Treasury yield has subsequently declined from December 18’s 2.82% to a recent 2.52%.
An even deeper slide by Treasury bond yields will increase the likelihood of a Fed rate cut. If the monthly addition to payrolls does not improve sufficiently compared to its pre-recession-like 20,000 jobs gain of February, a lowering of fed funds midpoint to 2.125% could occur as early as the June 19 meeting of the FOMC.
Containment of Core Inflation Rules Out an Extended Stay by 10-Year Treasury Yield Above 3%
In part, bond yields compensate creditors for inflation risk. The Treasury bond yield’s high correlation with the annual rate of core PCE price index inflation stems from how core inflation is a better proxy for the recurring or underlying rate of price inflation than is headline inflation.
January’s core PCE price index was up by 0.2% monthly and by 1.9% from a year earlier. Because many businesses now attempt to hike product prices if only because that is what the beleaguered Phillips curve tells them to do, core PCE price index inflation should temporarily run on the high side. In view of how recent price hikes have resulted in lower unit sales, any run-up by core inflation should be short-lived.
Note that softness in unit sales translates into slower growth for first-quarter 2019’s real consumer spending.
Soon, a number of businesses may discover they overestimated their pricing power mostly because of resistance from financially-stressed middle-class consumers. And, in response to unwanted inventories and an underutilization of production capacity, many of these businesses will rescind earlier price hikes. Accordingly, core PCE price index inflation may not soon enter into a climb that drives the 10-year Treasury yield above 3%.
Older Workforces Imply Slower Growth and Lower Treasury Bond Yields
When examining what correlates well with the 10-year Treasury yield, the biggest surprise has to be the yield’s 0.92 correlation with the percent of household-survey employment that is less than 35 years of age. Though the sample used to calculate the correlation excludes observations prior to 1985’s final quarter, when core PCE price index inflation raged during 1979-1982 and the 10-year Treasury yield was headed up to 1981’s record calendar-year high of 13.91%, workers aged less than 35 years of age reached a record high 49.5% of employment in 1979.
Younger workforces tend to be associated with faster growth for household expenditures, real GDP, and the core PCE price index. And this makes sense given that younger workers tend to be more actively engaged in household formation compared to older workers.
Moreover, though very young workers exhibit relatively rapid labor productivity growth, that is because their level of productivity is relatively low compared to workers belonging to the older age cohorts. In all likelihood, the relatively high productivity of workers aged at least 55 years is offset by their comparatively slow productivity growth.
Expectation of Fed Rate Cut May Lower Short-Term Debt’s Share of Corporate Debt
In anticipation of possibly lower short- and long-term benchmark interest rates, investor demand for variable-rate leveraged loans has shrunk. This far in 2019, AMG estimates that high-yield bond mutual funds averaged a net inflow of $746 million per week, while leveraged loan funds averaged a net outflow of -$758 million per week. By contrast for the comparably dated span of early 2018, high-yield bond mutual funds averaged a net outflow of -$1,257 million per week, while leveraged loan funds averaged a net inflow of $192 million per week.
Indeed, short-term debt’s share of nonfinancial-corporate debt shows a very strong correlation of 0.91 with the federal funds rate. For a sample beginning with 1984’s final quarter, the top and bottom of short-term debt’s share of U.S. nonfinancial-corporate testify to the considerable influence of the federal funds rate.
For example, short-term debt, or the outstandings of loans plus commercial paper, peaked at 47.4% of nonfinancial-corporate debt in 1985’s first quarter, or when the federal funds rate averaged a very high 8.50%. Years later, short-term debt bottomed at 24.9% of corporate debt in 2010’s final quarter, or when many correctly anticipated a long stay by fed funds at a record low 0.125%. Finally, previous expectations of an extended climb by fed funds helped to lift short-term obligations up to 31.7% of corporate debt by 2018’s final quarter. In view of current expectations of a flat-to-lower fed funds rate, short-term debt’s share of total debt is likely to ease.
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