Now that Greece’s debt crisis appears to be settled, at least for now, the U.S. Treasury market can return its focus to domestic issues. With the Federal Reserve likely to raise interest rates later this year and economic growth rebounding from the first quarter’s slump, that should mean higher yields, market participants say.
Gary Schlossberg, senior economist at San Francisco–based Wells Capital Management, expects the Fed to begin raising rates in December and for economic growth to total 2.5 to 3 percent for the rest of the year, following a 0.2 percent slump in the first quarter. He says that will put the ten-year Treasury yield at 2.6 to 2.65 percent by year-end, up from 2.4 percent currently.
“I think yields will ultimately move up, but the response will be more muted to the Fed’s rate increase than in the past,” he adds. “Fundamentals don’t argue for a strong move up.”
Whereas cyclical factors point to strength in the economy, some structural factors suggest weakness, Schlossberg maintains. On the cyclical side, there’s rising personal income and wealth, falling oil prices and housing affordability well above its historical average. All that augurs well for the consumer sector.
On the structural side, says Schlossberg, “there’s fundamental weakness in the job market.” That includes slow labor force growth and a mismatch between the demand for skilled labor and a large pool of unskilled labor. That’s leading to more discouraged workers. The labor force participation rate hit a 38-year low of 62.8 percent in June.
Meanwhile, the economies of many U.S. export markets are weak. And the dollar’s strength is not only curbing exports but also limiting domestic pricing power because of falling import prices, Schlossberg says.
To be sure, Subadra Rajappa, head of U.S. rates strategy for Parisian bank Société Générale in New York, thinks the strong dollar’s negative impact on exports is just about played out, with the greenback stabilizing over the past four months. SocGen currency strategists see only mild appreciation for the U.S. currency going forward.
The drop in capital expenditures because of lower oil prices is also old news, Rajappa and her colleagues believe. They predict economic growth will average 3.5 percent for the second half of the year, and Rajappa sees the ten-year Treasury finishing 2015 at 2.7 percent.
As for the Fed, she and Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets in New York, don’t think it will wait until December. Cloherty believes the Fed will act at its September Federal Open Market Committee meeting.
Although there’s talk that the Greek mess and China’s stock market stumble could hold the Fed back, “it’s unlikely the Fed will have a clear window in the foreseeable future,” he says. “If they skip September, then they have to worry about year-end liquidity in December. Moving off zero in a wildly illiquid market is a really bad idea.”
Things could get especially tricky for the Fed trying to raise rates in a low-liquidity environment, given that it’s likely to use the largely untested technique of reverse repurchase agreements to help push rates higher.
The International Monetary Fund has recommended that the Fed wait until 2016. But if the Fed moves in the first quarter, it will be tightening into a weak economy, if the performance of the past two first quarters is any guide, Cloherty notes. Gross domestic product shrank 2.1 percent in the first quarter of 2014.
He forecasts a 2.8 percent yield for the ten-year Treasury at year-end.
But Rajappa and Schlossberg see several factors leaving the yield a bit below that level. The European Central Bank’s 60 billion euros ($65.6 billion) of quantitative easing a month will push foreign investors to Treasuries in search of higher yield, she says. And financial turmoil overseas could do the same, Schlossberg points out.
In addition, muted U.S. price increases will keep long-term yields from going up much, he says. The personal consumption expenditures price index, the Fed’s favored inflation gauge, climbed only 0.2 percent in the 12 months through May. The Fed’s continued rollover of its maturing bond positions will also provide support for Treasuries, analysts say.
But the central bank’s rate hikes could roil the Treasury market more than in the past, they say. That’s because of the use of reverse repos and the fact that it’s not committing to raising rates at consecutive meetings as it has in the past. In addition, at some point, speculation will begin about when the Fed will taper its rollovers, which would increase supply in the market.
“Typically the yield curve flattens when the Fed raises rates,” Rajappa says. “This time it might flatten and then steepen between meetings, because it will be a guessing game [about whether the Fed will lift rates] at every meeting.”
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