No need to ring the alarm bell yet even as yield curve flattens to 10-year low
U.S. government shutdown threat is for late December, not Friday
ADP employment expected to show a solid increase
Weekly EIA report
No need to ring the alarm bell yet even as yield curve flattens to 10-year low — The yield curve continued to flatten on Tuesday with the spread between the 2-year and 10-year T-note yields falling to a new 10-year low of 53.4 bp. The sharp -31.1 bp drop in the 2s10s spread seen in the past six weeks (since Oct 26) has been due to a combination of the +20.3 bp rise in the 2-year yield and the -10.8 bp drop in the 10-year yield.
The 2-year T-note yield has risen in recent weeks on increased market expectations for Fed tightening. The market continues to discount a 100% chance for a +25 bp at next week’s FOMC meeting. However, the market has boosted expectations for rate hikes in 2018 by +11 bp since Oct 26 and is now discounting +44 bp worth of rate hikes in 2018 versus +31 bp as of Oct 26.
There has been a substantial amount of hand-wringing from market observers who believe that the flattening yield curve indicates that the U.S. economy is headed for trouble. Indeed, an inverted yield curve has often been a precursor to a recession in the past since an inverted yield is usually driven by a series of sharp Fed rate hikes. The Fed in the past has often overdone its rate hikes, thus tipping the economy into a recession.
However, we are not particularly worried about the flattening yield curve as yet because the Fed is raising interest rates so slowly and because the federal funds rate is still at a very low level from an historical perspective. Indeed, the current funds-rate target midpoint of 1.125% is still at a negative real yield level relative to the core PCE deflator of +1.4% y/y and 10-year inflation expectations of 1.89%.
Moreover, the 10-year T-note yield remains subdued largely because inflation expectations remain anchored. The subdued inflation statistics seen at present are a major positive factor for the economy since it suggests that the Fed can continue to move slowly with its rate hikes. The low level of longer-term Treasury yields supports the economy by making it cheap for corporations and consumers to borrow money for investment and home purchases. The continued low level of long-term rates at least partially offsets the negative impact from the rise in short-term loan rates.
As long as inflation remains subdued and the Fed continues with its slow approach to raising interest rates, the flattening yield curve is not likely to point to economic trouble ahead.
U.S. government shutdown threat is for late December, not Friday — House Speaker Ryan on Tuesday continued to have trouble getting his Freedom Caucus to agree to a new CR that extends spending authority to Dec 22 rather than their preference for Dec 30. Either way, it doesn’t matter right now because Congress appears ready to easily roll over the current CR that expires this Friday. The shutdown threat will be much more real when the new CR expires on either Dec 22 or Dec 30.
The House is currently expected to vote on a short-term CR on Thursday and a Senate vote should occur shortly thereafter, thus meeting Friday night’s deadline. Without a new CR, there will be a partial U.S. government shutdown at midnight on Friday. The markets at present do not appear to be worried about the prospects for a U.S. government shutdown, either Friday night or in late December.
The markets will be watching to see how Thursday’s meeting goes when President Trump is due to meet with Ryan/McConnell and Pelosi/Schumer to discuss a 2018 spending bill and other year-end legislation. Pelosi/Schumer canceled their appearance at last week’s White House meeting after a morning tweet by President Trump threw cold water on the chances for a deal.
Meanwhile on the tax bill, House and Senate leaders are negotiating behind the scenes to produce a common Republican tax bill that can pass both the House and the Senate. Several key Senators on Tuesday spoke against the corporate alternative minimum tax (AMT), which was positive for tech stocks. Tech stocks on Monday fell sharply, in part because the Senate tax bill last Friday night included a 20% corporate AMT. The latest betting odds are 75% for a corporate tax cut by year-end and 87% for a cut by March 31, 2018, according to PredictIt.org.
ADP employment expected to show a solid increase — The market consensus is for today’s Nov ADP employment report to show a solid increase of +190,000, which would be just below the 12-month trend increase of +202,000. ADP jobs showed a strong +235,00 increase in October, but that represented a bounce-back after hurricanes caused a weak +110,000 report in September.
The consensus for Friday’s Nov payroll report is for a solid increase of +197,000, which would indicate that the U.S. labor market continues to expand at a moderate pace. The unemployment rate in October fell to a 16-3/4 year low of 4.1%, indicating a tight U.S. labor market.
Weekly EIA report — The market consensus for today’s weekly EIA report is for a -2.5 million bbl decline in U.S. crude oil inventories, a +2.5 million bbl rise in gasoline inventories, a +500,000 bbl rise in distillate inventories, and a +0.3 point rise in the refinery utilization rate to 92.9%. U.S. crude oil inventories have tightened substantially in recent months and are now only +13.2% above the 5-year seasonal average. That is the tightest level in nearly three years and is much tighter than the +40% above-average level seen early this year. Meanwhile, product inventories are close to neutral. Gasoline inventories are +0.8% above the 5-year seasonal average and distillate inventories are +2.0% above average.