Thought of the day
11.07 - Yellen keeps the faith
Janet Yellen's twice-yearly Congressional testimony comes at a sensitive time for the bond market. In the past two weeks, the 10-year Treasury yield has climbed more than 20 basis points to close to 2.4%. Given Fed aversion to volatility, and recent market focus on weak wage growth and inflation, one might expect a less hawkish tilt.
But we think Yellen will stick to her recent message on gradual Fed tightening.
- Recent Fed comments suggest continued conviction in an inverse relationship between unemployment and inflation, with policymaker Bill Dudley warning "if we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation."
- While average hourly earnings rose just 2.5% in the year to June, the Atlanta Fed's wage tracker, which better factors in a changing mix of workers, had wages up 3.4% to May.
- Softening inflation appears technical and transitory, with the Fed in part blaming new unlimited-minute plans for mobile phones.
So, investors need to prepare for a steadfast Fed. We expect any hawkish tilt will be felt more in shorter dated securities rather than in longer dated assets. This is consistent with how traders have been positioning of late, with rising long positions in 10-year bonds and increasing shorts in the two-year Treasury. We forecast the two-year yield will rise from 1.4% current to 1.8% over the next six months, compared to a smaller magnitude 10-year shift from 2.4% to 2.5% over the same period.