An economically driven Treasury sell-off
There are many vague theories being discussed as to why Treasury yields have risen so much since January, but it isn’t that complicated. The Treasury market’s primary driver is the outlook for growth and inflation and the sell-off (rates higher) since January can be fully explained by these two things.
It all started last November. It was a strangely uniform month of weak top-tier economic data. ISM manufacturing fell 2+ points, non-farm payrolls missed expectations with a significant prior revision down, the unemployment rate rose to 3.9% and would’ve triggered the Sahm Rule if it were sustained, headline CPI and the PCE deflator were flat, and Industrial Production missed expectations. Then, at the end of the month (11/29), the Beige Book (which gathers anecdotal information from the Fed’s 12 districts) showed that an alarming eight of twelve Federal reserve districts were contracting. This condition is very rare and only seen near-to and within recessions.
Despite promoting “higher for longer” just weeks before, this seemingly scared the Fed because they had stopped raising rates in July and as often happens soon after that point, a recession starts. They had pressure to lower rates from their business constituencies (Beige Book), but also from the economic data. Governor Christopher Waller made an influential speech on 11/28 called “Something Appears to be Giving” where he made a point in the Q&A session to say that interest rates could be lowered soon just because inflation had fallen. The whole FOMC then amplified this lowering impulse at their 12/13 meeting; indicating a bias towards easing rates.
And so, this one month of weak economic data combined with the Fed’s reaction to it, fostered the conditions for the bond market to price seven 0.25% Fed rate cuts by the end of 2024 (as-of 1/16/2024.) Had the economic data released after November continued this weak, the Fed may have lowered this much or more. But it didn’t. The bond market extrapolated too far.
Top-tier economic data released in December began to rebound with the unemployment rate falling back to 3.7% and retail sales beating expectations by 3x. Then in January, payrolls beat expectations, Q4 GDP came in at 3.3% versus 2.0% expected, and consumer spending beat expectations. CPI was also hotter than expectations. In February, manufacturing ISM had risen back above 49 (from 46.7 in December), payrolls beat expectations by a huge 168k with a big prior upward revision, service ISM rose to 53.4, and CPI was hot.
Then in March, payrolls beat expectations by 75k jobs with core CPI a little hotter than expected and consumer spending better than expected. This month, payrolls beat expectations by 89k jobs, the manufacturing ISM survey rose above 50 (expansion), CPI inflation (core and headline) was hotter than expectations, and consumer spending rose more than expectations.
The Beige Book, which showed 8 of 12 districts contracting in November, has subsequently improved to 4 districts contracting in January, then 1 in March, and none in April.
More than just inflation being hotter, the economy has improved considerably since November and this is why interest rates have risen so much.
But, this says nothing about the future. Just like nobody predicted how uniformly weak the economic data released in November was, economic data will inevitably turn negative again based on the phase of the business cycle we are in. We are seemingly near the end of the expansion phase as told by the inversion of the yield curve, a deep fall in Leading Economic Indicators, the end of the Fed’s raising campaign, and more recently, the de-inversion of the yield curve. When the yield curve returns positive (10-year minus 2-year), it will be the final signal that a recession is imminent.
Because strong economic data and hotter inflation has caused interest rates to rise, weaker data will cause them to fall. We may have seen the first hint of this with yesterday’s weak Q1 GDP figure (1.6%), but more data is needed to know.