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I think the Phillips Curve has been broken. Long known for its historic and inverse relationship between unemployment rates and rates of inflation, it doesn’t apply today. Or at least for the past few years there doesn’t seem to be a correlation. Effectively the premise behind the curve is that as the unemployment rate moves down, inflation will move up (and vice versa). We’ve certainly seen the unemployment rate move down and over the past two years, inflation started to move higher before dropping even further. The graph below points out this observation with the red arrows. Inflation is not following the Phillips Curve.

And the Federal Reserve, in all of its stubbornness believes at some point the correlation will hold; it’s a temporary setback; the drop in inflation is transitory if you will. In the past 30 days they announced the unwinding of the balance sheet to begin this month as well as they plan to raise rates in December (market odds currently at 77% vs 23% a month ago). With PCE currently at 1.3% year-over-year versus their 2.0% target, how do you justify more rate increases and the unwinding of the balance sheet simultaneously?

The answer is and will always be the Phillips curve. It certainly cannot be related to the high probability of tax reform or infrastructure spending or any type of stimulus package coming out of Washington. That dream likely died not long into 2017. But a hawkish Fed is always to be respected and the current 2.35% on the 10 yr (which is up 30bps in the last month) is a result of the plans to unwind the balance sheet and raise rates again in December.

The good news, however, is that the Fed controls the front end of the curve, the overnight rate. Mortgage rates trade closely with the longer end of the curve such as the 10 yr Treasury and low inflation and subdued growth should keep rates low for the foreseeable future.

Economic Calendar

• Oct 12th PPI
• Oct 13th CPI
• Oct 19th Jobless Claims / Leading Index

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The Federal Reserve followed their telegraphed script by announcing the beginning of a large unwinding of the balance sheet in the FOMC meeting. The main details are as follows in how they will reduce the $4.5 trillion balance sheet:

• $6 billion in Treasuries and $4 billion in mortgage-backed securities to runoff each month
• Quarterly adjustments to that runoff with unspecified increases (leaves wiggle room)
• No time frame on when it’s complete and the ultimate size of the balance sheet (more wiggle room)

In addition, 12 members expect the Fed to raise rates by at least 25bps before the end of the year with only 4 expecting the benchmark rate to remain unchanged. Another interesting piece is that 14 members expect rates to rise next year (average of 3 times for 75bps) but there are two members who still expect no changes to the Fed Funds rate or all of 2018. I appreciate their skepticism.

The unwinding of the balance sheet will have some impact to interest rates. It is in effect a reduction in demand for Treasuries and mortgage-backed securities which will inevitably lower their price and raise their yield. And with the Fed’s majority believing one more rate increase is in store before the end of 2017, this was a pretty hawkish Fed meeting. But what wasn’t so hawkish was the market reaction which only saw the 10yr move up a few basis points to 2.28% today.

Now in terms of the reduction of the balance sheet and the runoff of Treasuries and mortgage-backed securities, there is a technical aspect that is worth explaining. As I mentioned above the reduction of artificial demand from the US Government will, all things being equal, raise Treasury yields. Mortgage-backed securities are priced off of Treasuries so if Treasuries yields go up, typically so do mortgage rates. When you combine that with the reduced purchases of mortgage-backed securities, that means those yields will move higher disproportionately versus Treasuries (meaning mortgage rates should move higher faster than Treasuries yields). That is assuming all things being equal. However you may see rebalancing of positions where more buyers are attracted to the higher mortgage yields. It’s hard to say at this point but something certainly worth watching. See graph below showing the 5yr Treasury yield, the generic mortgage-backed securities yield and in red, and the spread between the two. As you can see the spread has come down (meaning mortgages have traded very well relative to Treasuries in recent months). We could be in for a reversal and that spread increase, which would be bad for mortgage rates.

The big buoy for rates really is GDP and inflation. Not to mention there has been no tax reform, no health care reform, no infrastructure spending plan, geo-political issues with regard to North Korea and threats of nuclear war, plus several hurricanes now in the gulf of Mexico and Caribbean.

The Fed talks a big game with their plans for rates and the balance sheet; their opinions certainly have to be acknowledged and respected, but until there is real inflation, rates should stay close to where they are today. Let’s just hope the market’s reaction to the unwinding is muted.

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Don’t look now but the 10yr yield is almost trading with a 1 handle. With the 10yr down 37bps on the year and now trading at 2.06%, 1.99% is just in sight. This is a psychological barrier that could spark a game changing attitude about growth and the long term prospects for rates. The market was defiant at the start of the year with most calling for 4 increases to the benchmark rate. As of right now two increases, the one in March and the one in June are probably all that we will see in 2017. The hawkish Fed of 2017 is now back-peddling on rates. Just this week Kaplan said he wants to wait and see on inflation. Brainard said the Fed should move more slowly on rates until inflation is above 2 percent and Kashkari said the Fed may have already gone too far with rate increases. That’s about as dovish as you will hear the Fed given their stance earlier this year. The current odds for a Fed increase in December is 25% and when we have disasters such as Harvey and Irma, and potentially more in the forecast, those typically cause a short-term drop to interest rates.

Now is the time to capitalize on rates while they are low!

But before claiming victory we need to get below 2%. There is a good possibility the 10yr starts trading between 1.80 and 2.00%. The current 2.06% level is more transitory. It might pop back up between 2.10 and 2.40% or fall to a refi-inducing sub 2%. Incremental escalations with North Korea and/or Hurricane Irma should do it. A hurricane hitting south Florida will likely do significant damage and FEMA is almost out of money. The debt ceiling debate is still to be had and tax reform is taking a backseat to immigration reform. The dislocation in Washington is so large that action seems impossible. Hopefully politics will play themselves out and legislation is forthcoming. As it stands with another major hurricane on the horizon, things look bleak and that’s why the market has broken 2.10%.

Let me repeat however that we have not broken 2.00%. See graph below on the 10yr for the past year and a half.

You may be wondering about inflation in all of this. Not to worry as it hasn’t gone anywhere but down. See below for PCE as it has fallen below 1.5%. So much for the Fed’s target of 2.0% and their expectation we would reach it by year end. Time to re-adjust their forecast or perhaps Kashkari was right by saying that maybe the Fed went too far already. I’ve been a big critic of the Fed and their excessive optimism but we have to live by what the market’s opinion is and the falling 10yr and flattening yield curve suggests the market is becoming very pessimistic. More bad news will be a game changer.

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