Today’s February non-farm payroll release showed 235,000 jobs added which was above expectations of 200,000 jobs created and the prior month’s reading was revised up by 11,000 jobs to 238,000. The construction sector, helped by the mild winter weather, saw strong job gains of 58,000, the largest gain since March 2007; while the manufacturing sector saw robust gains at 28,000 jobs, the most since August 2013. The unemployment rate edged lower to 4.7% from January’s reading of 4.8% although the participation rate edged higher to 63 percent as more people entering the workforce found jobs. Average hourly earnings grew 2.8% yoy which was in line with expectations and the upwardly revised January figure of 2.8% yoy (from 2.5% yoy).
The market is now fully discounting a 25 basis point hike in the Fed Funds rate in March and further rate rises thereafter. At the time of writing, US Treasuries were little changed on the back of the figures. The key point is that the inflation backdrop remains benign and the Fed is moving ahead of the curve. Thus, our view remains that the yield curve will flatten and we favour positioning at the long end of the yield curve. If the US economic data points remain strong then it is likely that there could be an additional two 25 basis point hikes as the year progresses. Our proprietary models suggest that the 10-year US Treasury yield at ~2.60% is already discounting this.
Predicting the path of interest rates in the US beyond that is difficult without more detail on Donald Trump’s policies and knowing what he can get approved by congress. Trump’s speech to congress did not help in this respect. Moreover, there are always unintended consequences and a strong growth and higher rate scenario in the US is likely to be an unwelcome scenario for the ECB as it will increase pressure to adopt a less accommodative stance, particularly given inflation is picking up in Germany tracking at 2.2% yoy in February (preliminary estimate). This is potentially a toxic combination given the negative yields that a lot of European bonds at the shorter end trade on. Added to this is the high level of political risk with the elections in Holland, France and Germany.
In terms of positioning, we look to target the long end on a duration weighted basis and have been looking to manage our position by selling outperformers in the belly of the curve. Although Europe has creditor nations the lack of value on our models makes this an easy risk to avoid. While spreads in investment grade credit may not tighten significantly from current levels we still see opportunities from targeting undervalued credits with several notches of credit cushioning versus their rating and which trade on attractive positive yields.