10 Year Treasury Rate Falls Below 2.0% - Here Is Why There Is More To Go

Due to a cyclical slowdown in both growth and inflation, interest rates have been falling across the Treasury curve.

The 10-year Treasury rate has fallen below 2.0% for the first time since November 2016, blowing through the bearish reasons to "short" bonds at the last "blow-off" top.

As I have outlined in many of my past research notes, the driving factors behind US Treasury rates are credit risk, growth, and inflation. Currently, there is zero credit risk priced into US Treasury bonds so the analysis defaults to just the trending direction of growth and inflation.

Currently, the US is experiencing a cyclical slowdown in growth and a cyclical slowdown in inflation, both vectors which argue for lower, not higher, interest rates.

The cyclical slowdown in growth is very clear and can be judged by the EPB Macro Research Coincident Index (EPBMRCI), a composite index of income, sales, production, and employment. 

EPBMRCI
EPBMRCI | Source: EPB Macro Research

The cyclical slowdown in US inflation can be very clearly identified by breakeven inflation rates or market implied inflation expectations.

5-year, 5-year forward inflation expectations have dropped from 2.35% in February of 2018 to 1.82% today.

5y5y forward
Source: Bloomberg

The EPBMRCI and the market implied inflation rate does not tell you anything about the future direction of growth or the future direction of inflation. For that, we need to study leading indicators of growth and leading indicators of inflation.

At EPB Macro Research, we have various leading indicators of growth dynamics and inflation. Both measures continue to suggest that the trending direction in US growth and inflation have further downside.

On May 9th, I was part of a webinar in which I outlined my highest conviction call of lower interest rates.

Below is one of the conclusion slides I highlighted at the end of the webinar. 

Webinar

On May 9th, the 30-year Treasury rate was 2.87% and the 10-year Treasury rate was 2.45%.

Today, the 30-year rate has fallen to 2.53% and the 10-year Treasury rate touched 1.98%.

This move in interest rates represents a greater than 8% return in long-duration bonds.

Why have interest rates moved to the downside? Growth expectations and inflation expectations continue to trend lower.

One example of inflation (or lack thereof) comes from the employment sector. There are many analysts and economists, including Chairman Powell, that continue to wait for wage pressure driven by low unemployment to boost inflation. Not only has the Phillips Curve been debunked but leading indicators of wage pressure are pointing lower, not higher.

One fact to point out is that most investors and analysts alike are focused on the wrong measure of wage pressure. Many use average hourly earnings "AHE" which is not a true measure of aggregate wages but rather a ratio that rises when the denominator, hours worked, falls faster than the numerator. For a full breakdown of this misconception, click here.

The metric I use for income growth comes from the Personal Income and Outlays report from the BEA, not the average hourly earnings report from the BLS which is a misleading indicator of wage pressure.

Average hourly earnings is a ratio, which can rise if both the numerator and the denominator both shrink. Think about that.

If you earn $100 in 10 hours, you are earning $10/hour. If your income shrinks to $90 and your hours worked drops to 1 hour, you are earning $90/hour. Average hourly earnings growth soars but you have less to contribute to the economy and the Fed is supposed to raise interest rates in this scenario? How would this contribute to inflation?

Also, average hourly earnings have zero correlation to consumer spending and often rises in the dead middle of a recession.

Looking at the chart below shows the metric I use, wages and salaries from the BEA and average hourly earnings "AHE" from the BLS.

Wages and salaries growth (green) declines into the recession as it should and bottoms in the recession, accelerating into the economic expansion.

AHE growth spikes in the dead middle of the recession due to hours worked falling faster than weekly earnings and bottoms three years into the expansion.

The Fed was supposed to raise rates in late 2008 because "wages" were spiking? This is a misguided analysis and a misleading metric that everyone should throw out of their tool kit. Wages and salaries disbursements from the BEA correlates strongly to consumer spending and measures actual wage growth in the economy.

Wages BBG
Source: Bloomberg

If we take a look at the wages and salaries measure reported by the BEA, we can see that in nominal terms (including inflation) wage growth has decelerated since 2017 and is down almost 40% since 2014, strongly arguing against a major rise in inflation coming from the labor channel.

Wages BEA
Source: BEA, EPB Macro Research

When studying inflation, rather than calling for a rise in inflation due to "late cycle" or the commonly misunderstood fallacy of the Federal Reserve "printing" money, we should study cyclical drivers of inflation and the channels that a cyclical move in inflation can come from.

If we take leading indicators from the possible areas inflation can emerge, we can be alerted to any rise in inflation that may be brewing that would derail a position in fixed income which performs best during periods of decelerating inflation. Labor markets, commodities, currencies, credit, and money are five areas in which an inflationary spike will likely emerge. Essentially none of these areas are showing major inflation pressure.

Below is a metric of possible inflation coming from the labor market that focuses more heavily on the employment to population ratio rather than the unemployment rate, in addition to various other components.

EPB Wage Pressure
Source: EPB Macro Research

If we square the two charts above, we see how the wage pressure indicator has been moving lower since 2015, mirroring the chart of the growth rate in actual wages.

Given that the leading indicators of growth are continuing to move to the downside, in addition to a lack of price pressure coming from the main inflationary channels, the most probable environment over the next several quarters is one of decelerating growth and decelerating inflation. In an economic regime of lower growth and lower inflation expectations, we should continue to expect lower, not higher, interest rates across the entire curve.

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