The weakness in manufacturing and non-manufacturing ISM has set the tone for the start of October and the tone is risk-off, yet getting lost in the news cycle about ISM is the break-down in inflation expectations as measured by the market for Treasury Inflation Protected Securities (TIPS). We believe the TIPS market (Chart 1) is sending the Fed warning flares about the future path of inflation that in some ways is more significant than the deceleration of economic growth. The Fed wants inflation over 2% and today the break-even inflation rate on a 10-year TIP fell to 1.47%. This is the lowest level since 2016 and a real problem for a Fed that desperately wants to make sure a near 0% inflation rate/deflation never gets a strangle-hold on the US economy, as it has in Japan and threatens in Europe. The US dollar has been selling off the past few days (Chart 2) – and we believe this is a confirming indication that a Fed easing is on the minds of at least currency investors. The US dollar is weaker against both the Euro and even the British pound. When the US dollar is weaker against these currencies, there’s likely a problem. Whether that problem is the rising specter of impeachment, or FX traders detecting a more dovish Fed, the trend is important. The sell-off in the US dollar is inconsistent with the rally in Treasuries as a risk-off trade and suggests that the Treasury rally will be limited as long as the rest of the October economic data series is at least moderately healthy. The good news is we do not need to wait long for more data, tomorrow’s jobs report will likely be an important ingredient in the recipe for a risk-off or risk-on tone for October.
Figure 1: 10-Year TIPS
Source: Bloomberg accessed 10/3/19.
Jonathan E. Lewis
Chief Investment Officer