Bond Market Observations: Groundhog Day

The monthly formal review of portfolio strategy by the Active Fixed Income Investment Committee typically kicks off the first Friday of the month, as the release of the US employment situation sometimes materially influences our economic outlook. Proper and fitting that payrolls printed on February 2nd, Groundhog Day, because our initial reaction was "Didn’t we just do this?" Net employment gains in January were a touch stronger than expected, but the unemployment and participation rates were in line. The growth of average hourly earnings came in on the high side of expectations but meshed with our view that building cost pressures would put Fed tightening more meaningfully into play (with four moves in 2018 in the AMNA forecast) than market participants expected.

The comfort coming from the familiar lasted a few ticks past 8:30 am EST. Equity investors apparently recoiled in alarm that higher inflation and a firmer Fed would push Treasury yields higher. We are still not sure why this was scary. Monetary policy has to renormalize, and there is no better window to do so than when the economy starts at an unemployment rate near 4 percent and grows about one percentage point faster than its potential. Even a 1 percentage point increase in the fed funds rate leaves it below the Fed’s assessment of its neutral rate. That is, monetary policy remains accommodative in 2018. Nonetheless, a near $4 trillion reduction in US equity market capitalization commands attention, to be sure, especially when accompanied by a blowout in the forward-looking implied volatilities of those prices.

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