The Bond Market Is Going Crazy

Bond investors have finally done it, stretching out pricing for the next Federal Reserve rate hike beyond the point of absurdity — all the way to June 2018, according to CME Group's FedWatch tool.

Tuesday's market action saw the 10-year Treasury yield sink 3 basis points to 2.13%, briefly falling to the lowest level since Nov. 10, two days after Election Day reset expectations for the U.S. economy.

Yet the odds that financial markets are betting correctly about the rate outlook look minuscule at a time when so much is going right for the U.S. economy and the broader global economy.

Industrial commodities prices are surging, a reflection of the most broad-based global expansion in a decade. Wage pressures are building, according to the Paychex-IHS Markit Small Business Employment Watch, which on Tuesday reported 3% annual wage growth for the first time since the recession. The jobless rate is at a 16-year low 4.3% and numerous economists expect it to fall to 4.0% within a matter of months and keep falling.


Even tragedy may lift U.S. economic growth. While Hurricane Harvey's devastating floods will depress immediate economic activity, as the waters recede there likely will be a construction boom in Houston, with the need to replace thousands upon thousands of ruined vehicles.

Bank stocks have been paying the price for falling Treasury yields and the downgraded Fed rate-hike outlook, which cast doubt on the expectation of higher rates and wider net-interest margins that helped make the sector one of the winners of the postelection rally. Shares of JPMorgan Chase (JPM), Bank of America (BAC) and Morgan Stanley (MS) have all slipped below their 50-day moving averages. Bank of America and Morgan Stanley have both fallen below buy points, potentially negative signs advising investors to remain on the sidelines. JPMorgan remains in a buy zone above an 89.23 buy point from a double-bottom base.

IBD'S TAKE: Bullish chart patterns showing a stock breaking out of base into a buy zone give investors the best chance of reaping near-term gain, especially when a series of other important factors is present.

While headlines about North Korea drove a safety bid in Treasuries early on Tuesday, stocks recovered from early losses and turned in decent gains. The real game-changer for markets has been the disinflationary trend that has seen the Fed's preferred personal consumption expenditures annual inflation rate slide from 2.2% in February to 1.4% in June, with core inflation easing to 1.4% from 1.9%. (July figures are due out on Thursday morning.)

But markets are seriously overestimating the Fed's patience. The reason for the current consensus to keep rates on hold until at least December is that Fed policy makers have pretty clearly decided to use this window to shift their reinvestment policy and begin gradually scaling back the central bank's $4.5 trillion balance sheet. The change, allowing principal in maturing Treasury and mortgage bonds to run off, rather than reinvesting it, is itself a tightening of policy, so the Fed doesn't want to hike rates at the same time.

With wage growth creeping higher and the jobless rate sinking, Fed members are very likely to hike again sooner than markets expect. Industrial metals prices, a leading indicator of inflation, are on the rise, with copper, aluminum, and zinc all at multiyear highs, which has sparked breakouts of mining stocks like BHP Billiton, Southern Copper and Vale over the past week.

The weakness in Treasury yields as miners surge doesn't make a ton of sense. While higher commodity prices partially reflect dollar weakness, eventually that weak dollar will put upward pressure on prices of U.S. imports.

Hurricane Harvey could intensify an apparent shortage of construction workers, while a surge in used car demand could at least temporarily ease a supply glut that's weighing on used car prices.

Meanwhile, Trump policies also may have inflationary consequences. The Commerce Department is collecting preliminary duties of 17% to 31% on Canadian softwood lumber used in home building. Trump may decide this week to walk away from President Obama's deportation deferral program for people who arrived in the U.S. as unauthorized immigrants when they were children, which would gradually phase out their work permits.

While subdued inflation pressure reflects competitive pressures in a wide of array of industries, including the grocery industry that just saw buy Whole Foods, the inflation outlook won't be tame enough to keep the Fed on the sidelines for long with unemployment headed to 4%.

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