Bonds are the Donald Trump of the investment world. Most people hate them but they keep going up. Throw anything at them, these “Teflon” bonds can shake it all off. QEs or Fed hikes, risk-on or risk-off, $100 oil or $30 oil, strong dollar or weak dollar, you name it. The multi-decade march toward ever-lower yields seems unstoppable, not even by the zero line these days, and there is little sign a change in the trend is imminent (Chart 1). Those two die-hard bond haters still left out there, at least you don’t have to look at the hair.
What happened in May was another great example of how resilient bonds can be. Even with a string of hawkish-sounding Fed speeches and FOMC minutes that put a June/July rate hike squarely back on the table, the U.S. 10-year yield was essentially unchanged. G10 interest rates, on the other hand, dropped about 15 bps, capping the upside for U.S. rates.
Obviously, with the latest Yellen-pooper jobs report, June/July Fed hikes are off the table again, in our opinion. No matter how, and in what language, you read this report, it’s bad: a huge 5-standard-deviation miss and a big downward revision for the previous two months. The bigger question is whether this indicates the start of a new weaker trend or just a short-term aberration. For now, we are still in the camp of the latter. The recent economic numbers have been mixed, with manufacturing and housing showing upside surprises, while services and employment are lagging expectations. Overall, it still fits our “muddle through” view which is less optimistic than the Fed’s projection, but certainly not as pessimistic as that of the recession camp.
However, if the jobs trend weakens to a point where further wage growth becomes unlikely, the whole reflation theme that the market was hoping for would die off quickly. This would be a dollar-negative way to kill the reflation trade as a weaker underlying economy means a much lower path of Fed hikes going forward.
There is also a dollar-positive way to kill the reflation trade, which already happened in May. The damage from a more hawkish Fed was felt acutely in all inflation-sensitive assets last month. Break-even rates dropped sharply, showing another potential reversal like we have seen in the past couple years (Chart 2).
© 2016 The Leuthold Group www.leutholdfunds.com