Dodging a Bullet and a Missile

18 Sep 2017

  • US yields moved higher as concerns over Hurricane Irma and potential conflict with North Korea faded
  • The Federal Open Market Committee is on track to begin balance sheet normalization
  • US Inflation data a little firmer so we may see one more fed funds rate hike in 2017

Florida dodged a bullet as the worst fears over Hurricane Irma were fortunately not realized. The dangerous storm came ashore as a category 4 hurricane in the Florida Keys. On the heels of last month’s Hurricane Harvey this marked the first time ever that two Category 4 Atlantic storms made landfall in the US in the same year. Hurricane Irma stayed away from Miami and Tampa, instead moving up the central area of the state. The storm lost strength along the way and for the most part avoided major population centers. While Hurricane Irma undoubtingly caused a substantial amount of destruction, the damage in Florida was far less than anticipated allowing financial markets to breathe a sigh of relief this week. Spreads on fixed income risk assets, which had moved sharply wider the previous week as Irma approached Florida, snapped in on Monday last week. US equity markets also moved higher closing the week at or near all-time highs.

Geo-political events were also highlighted as the UN Security Council voted to impose additional economic sanctions on North Korea. Financial markets were somewhat calmed by a watered down version of the resolution which passed unanimously. North Korea responded with another intermediate missile launch over Japan on Friday. Markets largely shrugged off the missile launch, appearing to have grown immune to escalating tensions with North Korea. Likewise, a terror attack on the London subway system on Friday had little to no impact on financial markets, solidifying the notion that investors have grown numb to these types of events.

Hurricane worries and geo-political concerns had the US 10-year yields close to a new low for the year on Friday, September 8 at 2.06% after touching 2.01% earlier in the day. However the flight to quality rally was quickly unwound last week as the market perceived diminishing tensions with North Korea and saw far less damage from Hurricane Irma than anticipated. The 10-year yields finished the week at 2.20%. Risk assets performed well on the week with US high yield credit posting a 64 basis points positive excess return and the S&P 500 Index touching 2,500 for the first time, closing at a new all-time high at 2,497.

The market’s attention now turns to the Federal Open Market Committee (FOMC) meeting next Wednesday. The Federal Reserve (Fed) is widely anticipated to announce an October commencement of the tapering of their mortgage-backed securities (MBS) and US Treasury re-investments, and a gradual normalization of their balance sheet. US economic data has been positive with an upward revision from 2.6% to 3.0% to the second quarter’s gross domestic product (GDP) and a solid September payroll report. Thursday’s Consumer Price Index (CPI) release ended 5 consecutive misses to the downside of expectations. Core CPI was up 0.2% m.o.m. largely driven by an increase in the lodging component.

Near term trends suggest that US inflation is firming, which lends support to the Fed’s consensus projection for one additional hike to the fed funds rate in 2017, which would likely come at the December FOMC meeting. Current pricing of fed funds futures show market participants split about 50/50 over a December hike. Recent weakness in the US dollar, coupled with continued labor market strength, suggests that the Fed’s view regarding inflation moving towards its 2% target may in fact finally be right. That would come as a surprise to bond markets and it could induce US yields higher. So too would any more hawkish language from the Fed statement next week.

Download to read more