10-year T-note yield is knocking on 3-1/4 year high as breakeven rate rises to 2.09%
U.S. consumer sentiment will be watched for tax-cut optimism
Big risks for German political stability at Sunday’s SPD vote
Odds for U.S. government shutdown increase dramatically
10-year T-note yield is knocking on 3-1/4 year high as breakeven rate rises to 2.09% — The 10-year T-note yield on Thursday rose to a new 10-month high of 2.63%, which was just 1 bp shy of the 3-1/4 year high of 2.64% posted in Dec 2017 following the November election. A rise in the 10-year T-note yield above the 3-1/4 year high of 2.64% could lead to even bigger losses in the T-note market on some panic about that level being breached.
The 10-year T-note yield has now risen sharply by about +25 bp since November 2017 when the odds started rising for a Republican tax-cut bill, which in fact passed Congress in late December. The tax cut, combined with higher oil prices, have pushed inflation expectations significantly higher, thus pushing the T-note yield higher as well.
The 10-year breakeven inflation expectations rate has risen by more than +40 bp since mid-2017 and rose to a new 3-1/4 year high of 2.09% on Thursday. Even though the current PCE deflator statistics are subdued at +1.8% y/y headline and +1.5% core, the markets are expecting higher inflation in 2018 due to the strong U.S. economy, the tight U.S. labor market, and higher oil prices. Crude oil prices earlier this week rose to another new 3-year high of $64.89 per barrel.
Meanwhile, T-note yields have also been pushed higher by increased expectations for Fed tightening in 2018. In October 2017, before the odds started rising for a tax cut, the market was expecting only one +25 bp rate hike in 2018. However, the market is now expecting +60 bp worth of rate hikes in 2018, which nearly amounts to 2-1/2 rate hikes. Moreover, there is room for a further rise in Fed rate-hike expectations since the Fed is so far sticking to its forecast for three rate hikes totaling +75 bp in 2018.
U.S. consumer sentiment will be watched for tax-cut optimism — The market consensus is for today’s preliminary-Jan University of Michigan U.S. consumer sentiment index to show a +1.1 point increase to 97.0, reversing part of December’s -2.6 point decline to 95.9. The consumer sentiment index posted a 14-year high of 100.7 in October, but then fell by a total of -4.8 points in Nov/Dec.
The markets will be watching today’s consumer sentiment report for an early reading on how consumers are reacting to the tax-cut bill, which was passed in late December. The extra cash that most taxpayers will receive should provide a boost to consumer confidence and spending. However, consumers will not see much change in their after-tax paychecks in January because it will take about a month for the new tax withholding rules to be implemented. The impact of the tax cut may therefore take a few months to take effect.
In addition, polls suggest that nearly half of Americans opposed the Republican tax bill, which was perceived by many to favor mainly businesses and the rich. Therefore, the mass of consumers may not be particularly impressed by the tax cut and may not boost their spending by much.
Aside from the tax cut, other positive factors for consumer sentiment include (1) the sharp rally in the stock market in January to new record highs, (2) the steady multi-year rise in home prices, which is boosting household wealth, and (3) the strong U.S. labor market and rising income.
Negative factors for consumer sentiment include (1) the prospect of 50-75 bp worth of Fed interest rate hikes in 2018, (2) rising gasoline prices on the OPEC production cut, (3) geopolitical hot-spots such as North Korea and the Middle East, and (4) Washington political uncertainty with the Russian investigation.
Big risks for German political stability at Sunday’s SPD vote — The markets are eagerly waiting to see if some 600 Social Democratic Party (SPD) delegates at their conference in Bonn on Sunday will approve the draft of a coalition government with Chancellor Merkel’s Christian Democratic Union (CDU) bloc, thus approving the next step of moving into formal coalition negotiations.
Sunday’s vote is expected to be tight since many SPD delegates oppose another grand coalition with the CDU since the SPD in past coalition governments has progressively lost popular support. If SPD delegates on Sunday end up rejecting formal coalition talks, then Ms. Merkel would have only two choices. She could try to rule with a minority government or call for new elections.
Germany has already limped along for four months with a caretaker government. The odds are that the SPD on Sunday will agree to enter formal coalition talks. However, the markets on Monday will display concern if the SPD unexpectedly rejects the formal coalition talks, which would mean either a minority Merkel government or new elections. If a grand coalition is shot down on Sunday, then the euro on Monday is likely to take a hit and peripheral European bond yield spreads are likely to widen due to the political uncertainty at the EU’s core.
Odds for U.S. government shutdown increase dramatically — The odds for a U.S. government shutdown on Friday at midnight when the current CR expires increased dramatically after three Republican Senators said they would not support the House CR and Senator McCain will not be present for a vote due to illness. That means that McConnell does not have enough votes to keep the government open with the House CR even aside from the ability Senate Democrats to filibuster. Moreover, it appears that Senate Democrats are ready to go to the mat now over DACA, which also increases the chances for a shutdown. The markets are not likely to be overly concerned about a 2-3 day government shutdown. However, the stock market is likely to dip if a shutdown drags into next week.