BMA Market Insights: Fed On Track For December Rate Hike

Ten-year Treasury yields jumped to seven-year highs last week on the back of the Federal Reserve’s bullish assessment of current economic conditions. While the Fed kept its key rates unchanged, all signs pointed to a rate hike in December and continued rate increases throughout 2019. The benchmark ten-year Treasury yield reached 3.232%, the highest since May 2011.

Treasury yields could also feel upward pressure on supply/demand imbalances. Recent fiscal cuts coupled with increased government spending have contributed to a growing budget deficit. The need to fund the deficit has in part prompted an increase in Treasury issuance. Treasury supply has been further augmented with the Fed unwinding its balance sheet, by shedding securities. All the while, demand has waned, especially from Asian investors, partly due to a stronger USD and growing reserve balances. For example, the demand for 30-year Treasuries during last week’s auction was the weakest since 2009, which resulted in yields hovering around 3.4%, close to the long bond’s four-year highs.

Separately, stock indices globally rallied last week on the back of the U.S. midterm elections (see more below). Equity markets, however, took a beating towards the end of the week given weak earnings from technology stocks, volatile oil prices, and ongoing concerns regarding trade wars and the impact on global growth. Nevertheless, the major U.S. indices (i.e. S&P 500, Nasdaq, Dow Jones Industrial Average) all closed higher than where they kicked off the week.

I. U.S. Economic Data/Markets

Federal Reserve unanimously left its key rate unchanged at 2.00-2.25%, as largely expected. More interesting, was the Fed’s upbeat statement regarding the economic outlook, which increased the likelihood of a rate hike at the December meeting.
- Economic data since the Fed’s September meeting suggested that “ the labor market has continued to strengthen and that economic activity has been rising at a strong rate,” according to the Fed’s statement.
- Strong labor markets coupled with buoyant consumer spending seemed to overshadow any concerns regarding risks to the economy such as a softening housing sector.
- The Fed continues to have a watchful eye on escalating tariff tensions and their impact on corporate earnings and inflation.
  - Higher wage growth may add to inflation pressures as well. The October unemployment report indicated that annual wage growth picked up by 3.1%, reaching a nine-year high.
  - Higher inflation may prompt the Fed to hike faster than expected if inflation rates seem as if they will exceed the Fed’s 2% target.
- On the back of the statement, Fed futures priced in a 34% probability of the Fed funds rate reaching 3% next year, up from a 7% probability in August.
Oil prices continued its downward trajectory as increased U.S. supply offset demand, driving prices lower. Oil prices entered a bear market last week as prices dropped more than 20% relative to the highs reached last month. WTI traded as high as $76.41 a barrel.
- Reports from the Energy Information Administration reflected U.S. oil inventories reached a five-month high. Further, the U.S. Baker Hughes oil rig count showed that the number of active rigs drilling oil increased by 12 last week – the biggest rise since May.
- The selloff in oil prices prompted USD/CAD exchange to reach four-month highs, hovering over 1.323 during Friday’s trading session.
U.S. Midterm Elections: Democrats regained control of the House, while the Republicans gained a few more seats in the Senate.
- A balanced Congress seemed to push investors to a more RISK-ON mentality. Stock markets initially rallied on the back of the elections globally. Closer to home, the S&P 500 and the Dow Jones Industrial Average reportedly posted their best post-midterm rally in over three decades.

II. Other

Chinese Economics
- Exports surprised to the upside increasing 15.6% y-o-y versus an expectation of 11.7%, some market gurus believed that Chinese exporters are front-loading their activities given the expectation that U.S. tariffs will increase to 25% from 10% on about $200 billion of goods.
  - Further, the likelihood of any positive outcome regarding trade talks between U.S. President Trump and Chinese President Xi later this month remains low, according to some market practitioners.
- Imports also increased by 21.4% versus expectations of 12.8%. The jump may partly be attributed to China increasing its oil stockpiles, on the back of the U.S. announcing waivers for eight countries, including China to keep buying oil from Iran – despite U.S. sanctions on Iran coming into effect this month.
- China’s central bank, the People’s Bank of China, noted that the economy is facing downward pressure in a report last week. The bank intends to encourage financial firms to lend to small and private businesses to spur growth.
Brexit
- Prime Minister Theresa May’s cabinet is scheduled to meet this week to discuss the U.K.’s current position on Brexit negotiations. Issues surrounding the Irish border remains.
  - May needs to get her Brexit proposal approved by Parliament, with a vote potentially scheduled for later this month. While May’s Conservative Party remains split regarding a Brexit agreement, it no longer holds the majority within Parliament. The uphill battle for a resolution and uncertainty will likely place downward pressure on the pound.
- British Official, Jo Johnson resigned last week and called for a second referendum on whether the U.K. should leave the EU, noting that the negotiations are far from what was originally anticipated when the first referendum took place. The pound took a hit against the USD and Euro on the back of the resignation. He is the 14th official to resign from the government in the past year.
A revised budget from Italy is expected next week. If Italy and the EU cannot come to an agreement regarding the budget, downward pressure on the Euro versus the USD will likely remain. EUR/USD was trading close to 1.135 late last week, about 50 pips from its 2018 low of 1.13.

Key data/events this week: