This week’s stronger than expected September ADP report and a strong September non-manufacturing ISM report in conjunction with Fed Chair Powell’s comment that policy was ‘a long way from neutral’ has put bond markets under pressure. The glass has definitely appeared half empty rather than half full of late. All this has not been helped by a continued heavy Treasury issuance schedule to fund the burgeoning fiscal deficit. US fiscal stimulus at this stage of the cycle has significantly increased the risk of a policy mistake while trade tensions represent a significant risk to the global growth outlook. Amidst all this uncertainty and questions about the sustainability of this period of strong US growth today’s job report has sparked a lot of interest.
Today’s September non-farm payroll release showed 134,000 jobs were added which was below expectations of 185,000 jobs created although the previous month’s figure was revised up to 270,000 from 201,000. Clearly, with hurricane Florence impacting there is the potential for some distortions in the data: the BLS noted 299,000 people were not at work because of the bad weather. The unemployment rate edged lower to 3.7%, the lowest level since 1969, but in line with the FOMC projection for 2018 and they forecast it to go lower to 3.5% in 2019. The participation rate was unchanged at 62.7%. Importantly, average hourly earnings were in line with expectations rising 2.8% yoy compared to the previous month’s figure at 2.9% yoy.
While market expectations for further tightening has increased, inflation expectations look to still be well anchored: the five year US breakeven rate remains close to 2% and comfortably in the middle of the range for this year. Indeed, Fed Chair Powell commented in his speech on 2 October: ‘We attribute a great deal of the stability of inflation in recent years to the anchoring of longer-term inflation expectations. And we are aware that it could be very costly if those expectations were to drift materially. As you probably know from our public communications, we carefully monitor survey- and market-based proxies for expectations, and we do not see evidence of a material shift in longer-term expectations.’
Longer-dated bonds are heavily influenced by the inflation outlook thus longer-dated Treasuries look oversold on our models. Plus, with Treasury short positions at elevated levels and the 10 year Treasury now offering a real yield close to 1% there is certainly scope for a brutal short-covering rally at some point.