Three steps and yields stumble

"Three steps and a stumble" is an old market adage that foretells of a drop in the US equity market after the Fed's third interest rate hike.

This is turning out to be a doozy so far - the Fed already completed rate hike number three on 15 March 2016, and yet US equity market indices remain at or near record highs. Maybe the Fed's "unconventional" monetary policy - and lately, Trump - has rendered this "wise old saying" obsolete.

Also, the Fed's three rate hikes since December 2015 has taken the fed funds rate to a still very low 0.75% - 1% (and they're still reinvesting the principal payments from their portfolio holdings).

The recent decline in 10-year US bond yields suggests that this adage may have jumped over into the bond market. The yield on 10-year US Treasuries closed at 2.33% last week - a 30 basis point stumble from this year's high of 2.63% recorded on 13 March (a day before the Fed's 14-15 March FOMC meeting that concluded with the announcement of the third rate hike in the current cycle).

Apart from concerns about the implementation risks over Trump's reflationary policies, the latest data releases - which on balance disappointed market expectations - helped bring long yields lower.

While the University of Michigan consumer sentiment index rose to its best level since January this year 97.7 in May from 97.0 in the previous month and beat market expectations for an unchanged reading, retail sales disappointed.

Overall retail sales grew by 0.4% in April from 0.1% in March, less than expectations for a 0.6% gain. Core retail spending increased by 0.3% over the month, also less than the expected 0.5% growth. Admittedly, these are one months' figure and the lead from the strong labour market and elevated could see a rebound in the coming months. But the year-on-year rate of growth in core retail spending had been steadily slowing from 5.4% expansion in January this year to 4.5% last month.

Closer and dearer to the US bond market's heart is the latest CPI inflation stats - both the headline rate the core measure came in lower than market expectations.

Headline CPI inflation eased to 2.2% in the year to April from 2.4% in March and 2.7% in February. This is the slowest rate of price growth this year and is below market expectations for a 2.3% increase.

Core inflation wasn't any better, slowing to a year-on-year rate of 1.9% (below target) last month from 2.4% in March. This is less than market expectations for a 2% increase and marks the third straight month of slowing core consumer prices and is the lowest rate since October 2015.

If the University of Michigan's consumer inflation expectations index is any guide, further easing in inflation is in store, Inflation expectations over the next five years fell to 2.3% in May - on par with the record low reached in December last year.

This is in line with inflation expectations measured using the yield differential between nominal US Treasuries and TIPS (treasury inflation protected securities). The 10-year yield differential currently stands at 1.82% - down from 2.0% (when the Fed announced its third hike on 15 March) and 1.94% at the start of 2017. The five-year yield differential currently stands at 1.74% - down from 1.82% (when the Fed announced its third hike on 15 March) and 1.83% at the start of 2017.

These figures have reduced the odds for a Fed rate hike next month but financial markets are still betting on one with the probability tracked at 70% (from 80%).

But wouldn't this further inflationary pressures and lower inflationary expectations some more?

Read more: FedTrumpUniversity of Michigan10-year US TreasuriesFOMCHeadline CPI
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