Fed Speculation Continues to Dominate Trading Ahead of NFP

Stocks sold off with Treasuries while swap spreads continued to tighten as markets set up for tomorrow’s all-important nonfarm payrolls report.  Yesterday’s testimony from Fed Chair Yellen coupled with stronger-than-expected US data boosted expectations for a rate hike in December.  Today’s economic reports were consistent with the theme.  Data showed US jobless claims rose to 276,000 (versus 262,000 estimate), but remained significantly below the 300,000 threshold, which is representative of a healthy job market.  A separate report showed manufacturing productivity unexpectedly increased at its fastest pace in four years.  The overall trend in productivity remains weak, but the jump is a positive development because over time increased productivity leads to higher wages.  Just last night Fed Vice Chair Fischer spoke to low productivity growth holding back wages.

Another development worth mentioning is the recent dislocation in US interest rate markets.  Swap spreads, which represent the difference between the yields on US Treasuries and the interest rates on swaps with the same maturity, have become significantly out of whack.  Spreads are typically positive, with swap rates trading above like term Treasury yields, but this is not currently the case.  Spreads have tightened to the point where most maturities on the swap curve now have a negative spread to Treasuries.  There are a number of theories as to why this is happening, but major contributing factors include new bank regulations that increased capital costs, the bevy of corporations issuing debt, and large selling of Treasuries from foreign central banks ahead of a potential rate hike.  This dislocation would typically be exploited by hedge funds and other fast money types, which would cause the spread to widen back out, but new bank regulation has made that trade a very capital intensive proposition for dealers.  This is likely an unintended consequence caused by regulators, and it’s unclear what will drive the relationship between Treasuries and swaps to normalize.  The following chart from Bloomberg shows the history of 10-year swap spreads.