Rising Demand For Treasuries & Falling Inflation Expectations

US labor productivity rebounded in the second quarter rising 1.3%–a solid revival from Q1’s 1.1% decline (revised up from the previously estimated 3.1% decline). But the trend remains weak—productivity increased only 0.5% for the 12 months through June. Yet labor unit costs are rising at a much faster rate—up 2.2% in year-over-year terms through Q2. “What it means is that inflation could be more problematic down the road, but we haven’t seen it yet,” says Gennadiy Goldberg, an economist at TD Securities. “It’s something to think about long term.” For the moment, however, the Treasury market appears to be preoccupied with other matters, namely, the risk that disinflation is gaining the upper hand once again.

The benchmark 10-year yield continued to fall in yesterday’s trading, dipping to 2.15% on Aug. 11, according to Treasury.gov data. That’s the lowest yield since May. Last month’s selling that pushed the 10-year within a few basis points of 2.50% suddenly looks like ancient history.


The 2-year yield, which is considered the most sensitive spot on the yield curve for to expectations, remains relatively firm by comparison. Nonetheless, the upside momentum that characterized this maturity has eased lately, with the 2-year yield dipping to 0.68% yesterday, the lowest in more than a week.

Renewed concerns about global growth in general—and China in particular—have fueled a new phase of risk-off trading. The preference for safety contrasts with recent expectations that the Federal Reserve’s first interest rate increase since 2006 was near, perhaps as early as next month. But in the wake of this week’s news of China’s currency devaluation—widely seen as a response to decelerating growth in the world’s second-largest economy—the prospects are looking shaky again for tighter monetary policy in the US. In line with that view is the expectation that the US dollar will continue to strengthen, which will act as a drag on growth to a degree by making US products less competitive in the global market.

Meanwhile, the market’s outlook for inflation has been easing, based on the yield spread for nominal less inflation-indexed Treasuries. The implied inflation rate via the 10-year notes, for instance, fell again yesterday, slipping to 1.65%–the lowest since March.


China’s devaluation—yesterday’s nearly 2% slide against the US dollar was the yuan’s biggest one-day loss in two decades—will take time to work through the global economic system. But “it’ll more likely slow the Fed’s trajectory rather than delay [its] first hike,” predicts Guy LeBas, chief fixed-income strategist for Janney Montgomery Scott. Maybe, but Mr. Market’s recent activity leaves room for doubt that the monetary squeeze will start in September.

Why? One reason is that even slightly higher rates in the US will look that much more attractive in a world that’s increasingly anxious about China’s macro outlook. In turn, there’s a risk that a renewed appetite for dollar-based assets may drive the greenback higher—and long US rates and inflation lower.

In short, the notion that the Fed will begin raising rates next month is once again open for debate.