Interest rates remain under pressure due to ongoing positive economic data and signs of potential inflation. Those pressures were fueled earlier in the week by a misleading report that China may slow or halt purchases of U.S. government securities which pushed yields higher on Wednesday before retreating when the accuracy of the report was called into question. Chalk it up to “saber rattling” by China as the U.S. continues to try to negotiate better trade deals with the Middle Kingdom. While bonds did wind up rallying after the report was confirmed to be inaccurate, one must be reminded how delicate the balance is between our trading partners. China owns over $1.2 trillion of our outstanding $6.3T in treasuries which represents 19% of the pot. Why does China buy our bonds? China buys our bonds so that the U.S. keeps buying inexpensive manufactured goods from China. It is a situation where both countries have mutually benefited for a long time and disrupting this relationship could have severe consequences.
The key economic reports this week were the Producer Price Index (PPI) and Core Consumer Price Index (CPI) readings. While the PPI reading was tame, the CPI readings, which strips out volatile food and energy, saw its largest increase in 11 months with year-over-year CPI increasing from 1.7% to 1.8%. With the pro-growth policies in place, the threat of inflation is real and if inflation rises unexpectedly it will negatively affect bond yields and interest rates. Couple the threat of inflation (actual confirmation that inflation is rising has not been verified) along with record property and equity markets leaves the Fed confronting some difficult decisions in the coming months with respect to how to raise interest rates gingerly while still protecting the economy from a potential bubble(s). It will be interesting to see how the new Fed chairman responds to these potential challenges.
While at the time of this writing the all important line in the sand of 2.62% on the 10 Year Treasury Note remains intact, we are mindful of the fact that the probability is that interest rates go higher rather than lower. Therefore, we continue to remain biased toward locking in interest rates which are still very attractive historically at current levels.