Interest Rate Weekly: Middle of the Curve Moves on Better Economic Data

Last week’s impressive employment report for June began to raise questions about the timing of monetary policy actions going forward. The middle of the yield curve has begun to reflect the better economic data.

Better Job Growth, Less Doubt  

June’s employment report showed another month of impressive job gains, rising 288,000 with broad-based increases across a number of industries (top graph). In addition, prior months’ data were revised higher, thereby, further adding to the case for stronger economic fundamentals. The unemployment rate, which has been hovering around 6.3 percent for the past couple of months, declined to 6.1 percent. Over the course of the past 12 months, the unemployment rate has declined by 1.4 percentage points. Some of the improvement has been due to demographic factors that have pulled the jobless rate lower; however, solid job growth has begun to play a more significant role recently. Besides the stronger job gains and lower unemployment rate, initial jobless claims have come down to their pre-recession levels. To us, the labor market data suggest that there is not as  much slack as the Federal Reserve has let on. The evidence at this point seems to point toward an economy approaching full employment. The implication of less slack in the labor market translates into a potential change in timing of Federal Reserve’s first tightening move. 

Full Employment and Interest Rate Relationships

When looking at the middle of the yield curve (two-year and five-year U.S. Treasury yields) in the wake of last Thursday’s report, it appears that some doubts have begun to be raised about the timing of monetary policy. Following the employment report, the yield on the two-year U.S. Treasury note reached 0.52 percent (middle graph) while the five-year yield approached 1.74 percent, a marked rise from the 1.63 percent observed on June 30. Less affected by short supply than the longer duration Treasuries, the middle of the curve appears to be doing a better job of capturing domestic economic fundamentals. 

Rate Hike Next Summer, Expect Rates to Move Earlier

We still maintain our view that the Fed will not raise the short-term Fed Funds rate until next June. However, we do expect market-determined rates, particularly at the shorter end of the curve, to move in anticipation of the Fed’s move, pulling yields gradually higher later this year and the first part of 2015. The FOMC maintains that the pace of tapering and changes in monetary policy remain data-dependent and still believes that the appropriate timing of a policy move is next year (bottom graph). With continued signs of less slack in the labor market, more solid economic growth and the prospect of inflation edging higher, some risk of a change in the timing of Fed tightening has begun to emerge. Data in the coming months are likely to continue to reflect an improving economic environment, and thus, interest rates are likely to continue to edge slightly higher. Yields at the longer end of the curve continue to be held back by increased geopolitical concerns and tight supplies.