US: Interest rates are most important influences in the capital markets - BBH

The research team at BBH suggests that the US interest rates are arguably among the most important influences in the capital markets and the softer than expected retail sales and inflation report before the weekend spurred a pullback in US interest rates.

Key Quotes

“The two-year yield slipped four basis points to finish the week below 1.30%, snapping a two-week advance.”

“Expectations for Fed policy next month did not change substantially.  Bloomberg's calculations suggest the June contract is pricing in a 97.5% chance of a hike next month, down from 98.8% the previous week.  The CME's model suggests the odds were unchanged on the week at 78.5%.”

“Our estimate would suggest about a 73% chance of a June hike is discounted.  This assumes that Fed funds would average 116 bp after a hike (which, relative to the range, is where the effective Fed funds rate has been averaging) and that on the last day of the quarter the effective rate drops nine basis points, as it did at the end of Q1.  At the end of the previous week, our calculation put the odds at nearly 77%.  Even incorporating the July and August contracts into our calculations, we don't see the market discounting more than a 76% chance.”

“There is a risk the April core PCE deflator pulls back further when it is published at the end of the month (May 30).  Recall it peaked in January near 1.78% and in March stood at 1.56%, which was the lowest since March 2016.  Any further slippage, which the CPI (and softer rents) hint at, would see the Fed's preferred inflation measure ease to its lowest level since the end of 2015.”

“At the same time, inflation expectations have fallen.  Before the weekend, the University of Michigan's survey found the 5-10 year inflation expectation fell back to the 2.3%, the cyclical low from the end of last year.  The 10-year breakeven (the difference between the conventional yield and the 10-year TIPS) has moved to the lower end of its range since last November.  The US yield curve (two-year to 10-year yield) has flattened considerably.  When the Fed hiked rates in mid-March, the spread was about 120 bp.  Now it is threatening to push below 100 bp.”

“The US 10-year yield fell last week for the first time in three weeks.  The yield had been gradually rising in five of the past six weeks.  The setback in response to data is threatening to continue.  The downside gap created on April 24 in response to the first round of the French election lies near 2.24% may draw prices.  Mixed signals are expected from the first round of the Fed's May manufacturing, while the April housing starts and industrial output figures recovery from the March weakness, but might not be sufficient to push US yields higher.”

“And without higher US yields, the dollar may not find much traction.”