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Fed Expectations

8 July 2016 by Mark Holman

The data to watch out for today is the change in the US nonfarm payrolls report, which is released at 13:30 BST. The US has been impressively adding jobs over the last few years at a rate well over 200,000 per month on average. In the last quarter however, this growth had slowed down, but no-one expected a figure as low as May’s data showed, which was a gain of just 38,000 new jobs. Naturally, as the economy nears full employment, there should be a slowdown in new jobs, and this should ultimately lead to wage growth which eventually feeds into rate rises, but this was a long way below market expectations of 160,000 new jobs.

This fall in May was so severe that it caused the market to reconsider the health of the economy, and importantly for fixed income investors, caused them to reduce their expectations for US rate hikes. Combining this with the negative shock of the Brexit vote, the market now expect very little from the Fed; in fact market-based expectations are now indicating that there is just a 24% chance of just one 25bp hike, in the next 12 months.

The market however, does not control US rate policy; that is the job of the Federal Open Markets Committee (FOMC), and the FOMC have been consistently stating that they will raise rates further this year. At the beginning of the year, we were told to expect 3 to 4 hikes in 2016, and while this had been revised down to between 1 and 2 hikes last month, it is still radically different to what the market now expects.

This change in market expectation, along with the general risk off sentiment, has allowed a very strong and sustained rally in US Treasury bonds to take place. At the time of the first hike last December, the yield on the 10 year was 2.35%, today it is almost 100bp lower at 1.38%.

However, although the yield has fallen significantly on the one hand, US Treasuries still look cheap compared to other genuine risk off government bonds. For example, the € Government Bond complex, excluding the periphery, has an average yield below zero, the Swiss curve and the Japanese curves are almost entirely below zero, and now here in the UK, Gilt yields have been collapsing as the market awaits a rate cut, and other possible actions from Mark Carney.

Nevertheless, should the Fed follow through and deliver rate hikes in the US, then Treasuries look very much overpriced, and yields can be expected to reverse sharply.

For this reason today’s data is so important, as the market has almost completely discounted any Fed action. A poor jobs report would vindicate the market and therefore the view that Treasuries are cheap, but a robust set of jobs data could catch the market off guard and bring the words of the FOMC members back into focus.

As far as data goes, it is probably as exciting as it gets.

So for those who wish to partake in the fun, here is what the market is expecting for today:

Change in Nonfarm Payrolls: +180,000

Unemployment rate: 4.8%

Average Hourly Earnings Year on Year: +2.7%

Our own view incidentally, is that we have been enjoying the rally in Treasuries, but have been booking profits on our 30 year bonds that we held as “Brexit hedges” as the market has forgotten about the words of policy makers and has potentially overshot.  We would happily own them again given the market uncertainty, but only upon verification of a poor set of jobs data, so that we too can forget about the words of policy makers.

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