US Treasury Market At Odds With Fed Rhetoric

The market's focus appears to be shifting back onto the interest rate cycle, as headline risks surrounding Greece abate.

Recent comments by policymakers from both the Federal Reserve and the Bank of England seem to be priming the market for rate rises.

US treasury and UK gilt yields have so far provided a muted response, although we have seen more volatility among commodity currencies over the past week.

Those moves have been related to oil prices falls in response to the Iranian nuclear deal coupled with the Bank of Canada's decision to cut interest rates.

However, we also believe these trends are indicative of a renewed focus on the Fed tightening path.

In her semi-annual testimony to Congress, Chair of the Federal Reserve Janet Yellen stated that rates will rise this year, notwithstanding the caveat that the Fed remains data dependent.

Yellen may well have been playing to her audience, the Committee on Financial Services, but nonetheless she provided a generally optimistic outlook on the US economy, noting, "prospects are favourable for further improvement in the US labour market and the economy more broadly."

The US treasury market remains at odds with Fed rhetoric and it is not yet convinced that the US recovery is fully ensconced.  

A poor retail sales number in June has added to that uncertainty, while manufacturing data continues to flounder on a strong US dollar and weak foreign demand.

However, we are encouraged by the Federal Reserve's Beige Book, which we believe is a more comprehensive assessment of the US economy.

In all 12 Federal Reserve Districts, an expansion of activity was reported, including improvements in consumer spending, ongoing strengthening of the labour market and improving activity in certain areas of manufacturing.

As Yellen was reporting to her legislature, the Bank of England Governor Mark Carney stated to Parliament's Treasury Committee: "The point at which interest rates may begin to rise is moving closer."

This explicit guidance adds to hawkish comments made by other policymakers, Including David Miles, once considered a 'dove', who suggested that he might vote for a rate hike at August's meeting- potentially, he would be joining two other 'hawks' of the nine-member Monetary Policy Committee (MPC). Although consumer prices remain subdued, improving wage data (average earnings increased 3.2% in the three months to the end of May) is mostly likely stoking concerns about longer-term inflationary risks.

Other members of the MPC are less convinced, as is the market which is discounting a first Bank of England rate hike in the second quarter of 2016. Andrew Haldane has warned about the risks of undoing the current policy stance too quickly, potentially making a difficult situation worse.

Policymakers' dilemma in both the US and UK is not just about delivering the first rate hike, but they are also focusing on the path of the interest rate trajectory over the next two to three years. A number of these policymakers are concerned that the longer interest rates are held at zero, the greater the risk that rates will have to move at a faster pace, even to achieve a lower 'neutral' rate.

This latter concern has been more audible of late, and there is a risk of complacency settling into markets.

Month-to-month economic data reports will likely keep bond markets volatile in the near term.

Nonetheless, we have again been shortening duration in portfolios, in part predicated on the view that rates will rise faster than the markets suggest.