Busy Week for Central Banks

Lawrence Gillum (00:00):

Hello, and welcome to this week's LPL Market Signals. Lawrence Gillum here, Chief Fixed Income Strategist on the LPL Research team. And I am your host this week. It is a busy week for Central Banks. We have the Federal Reserve, we have the European Central Bank. We have the Bank of England and the Bank of Japan to name a few. So to help unpack what these central bank meetings could mean for the fixed income markets, pleased to be joined by our Chief Technical Strategist, Adam Turnquist. How are you today, sir?

Adam Turnquist (00:27):

Hey, good afternoon, Lawrence. Great to be here. Great to get back to my roots in the fixed income space. Happy to talk a little technicals on what's going on in the fixed income space.

Lawrence Gillum (00:36):

I was going to bring that up. It's great to have you here. Not only are you a pro at the charts, you have the fixed income background as well. I'm looking forward to this discussion. It should be a busy week for the rates markets and potentially the credit markets. We'll look at the credit markets as well, they've been sound asleep for the past couple of weeks. We'll see if this wakes them up or not, but we'll take a quick look at the credit markets too. Why don't we get started, Adam, with just maybe giving us a lay of the land, how you're looking at the rates markets. We will start with the two-year yield, if you don't mind. It's the most correlated to monetary policy, and given that this is a big monetary policy week, what are the charts telling you as it relates to the two-year?

Adam Turnquist (01:22):

Alright, we'll start on the front end because the message there I think is important. This is probably the chart I'm looking at most right now from a technical perspective, because there's been a lot of developments over the last couple of months, the two-year yield technically reversing this downtrend. It was really just range-bound as the market was, we'll call it, complacent on the Fed cutting rates for most of this year, and then coming into this year, so call it low 3.40s to the upper end of that range, 3.63. We broke out of that range before the war started to unfold, before the summary of economic projections in March. We've gotten back above the 200-day moving average. We actually cleared the Fed funds upper end at 3.75. I think today we're trading around 3.80.

Adam Turnquist (02:12):

I didn't get the latest update, but somewhere around that level. And the message from the fixed income market, I think, is that the idea of the Fed cutting rates this year is not a foregone conclusion. There's a lot of uncertainty. Of course, you can attribute that to what's happening in oil, with yields following oil higher. But I think there's a big question mark from the fixed income side. There's not as much, we'll call it, complacency or optimism for Fed cuts on the front end of the curve. I think that's probably the chart, if you're going to put one in there, that keeps me up at night. Outside of my 2-year-old and 4-year-old boys, I'd say the two-year yield right now is a little more concerning when you think about a catalyst for equity markets, that being the Fed cutting rates. Now, that can change if oil moves lower, we get some type of ink dried on a ceasefire agreement, and the Strait of Hormuz reopens. We'd like to see two-year yields get back into that range, below 3.63. I think that would be a constructive sign for equity markets as well.

Lawrence Gillum (03:16):

Great points. Since the start of the Iran conflict, the two-year yield is higher by about 42 basis points. As we record this on April 27th at one o'clock on this Monday, we are slightly higher again on the day. But over the past month or so, the front end has sold off more than the back end on those rate cut expectations getting priced out. At one point a couple of weeks ago, markets were pricing in rate hikes, we felt that was overdone. Markets are still pricing in a no-action Fed at least until the middle of 2027, perhaps towards the end of 2027. We'll see if that's right or not. That may be a bit overdone, but we have seen some pretty dramatic repricing in the front end of curves. Let's take a look at the 10-year, at 4.34 right now. It's higher since the start of the war, but not as much as the two-year as we just talked about. It's back into what you could call a range now, but what are the charts showing you with the 10-year?

Adam Turnquist (04:27):

So we'll call it uncomfortably high. When I look at the 10-year chart right now, and to get perspective on our framework and how we're thinking about 10-year yields, you have to zoom way out and go back to 1981. 10-year yields topped out at around 15.80%. And that was the start of what we call a secular downtrend in rates. Inflation was running hot, we had oil moving higher. Volcker came in and broke the back of inflation, raising interest rates to 20%. That was the peak in 10-year yields. And since then, yields have enjoyed this downtrend, lower lows, lower highs, all the way until 2022. And that's when that trend started to change. Of course, we know what happened. The Fed raised interest rates aggressively in March 2022, and we reversed that downtrend. Now, technically, the longer a downtrend is in place, the more meaningful it is.

Adam Turnquist (05:19):

And certainly when you break out above that downtrend, that's a pretty significant technical development. It doesn't mean you immediately move into a sharp uptrend, but it raises the probability there's some upside risk in the market. And I think at minimum, at least technically, I'd make the call that it really marked the end of zero interest rate policy going forward. And even if we see a crisis, I don't know if the Fed will take rates down to zero again, I think you can technically make the case that that era is over. Now, when you zoom in a little more granular and look at price action over the last few years, we have been range-bound. Interestingly enough, we're right around the levels we witnessed in October 2022, which was in line with the bear market low. Equity markets have really enjoyed this range-bound price action, we'll call it 50 basis points above or 50 basis points below that 4.25 level.

Adam Turnquist (06:13):

But we're getting to the point of this apex of this consolidation phase, and that's where I get a little concerned. If we break out to the upside, you'd need to see a move above 4.64, a breakout there would raise the risk of maybe 4.80 or 5%. I don't think the equity market can really absorb that, given where growth expectations are now and where they've come from. They've been revised lower, of course, with what's going on with Iran. But zooming in one more degree and looking at this latest move off the lows in 10-year yields, we did get above 4.30, that was a little concerning, got above the 200-day moving average. So right now I look at 10-year yields with the potential for upside risk to maybe 4.50 or 4.60. Now, the good news, if there is any for interest rates, is their price reaction to oil this month compared to last month has been a lot more muted.

Adam Turnquist (07:10):

If you look at the surge we had on a daily basis in oil in March, interest rates reacted quite aggressively. We're not seeing the same type of reaction. Even today, you can make the case yields are up a few basis points with oil, WTI or Brent, up a couple percent. So I think the fixed income market right now is saying, look, we've seen peak oil, there's asymmetric risk to the upside here, but we're not quite comfortable with what that means for inflation and what that means for growth.

Lawrence Gillum (07:41):

Great points about the lack of movement out of the rates market, particularly the back end, despite rising oil prices. If you look at things like breakeven inflation expectations, we've been talking about the difference in market pricing in terms of inflation expectations for the front end, two years, three years, four years, versus something like a 10-year out. Markets were pretty concerned about inflation increasing over the next couple of years, but not as concerned about this being a full reversal and revisiting the seventies and eighties inflationary dynamics. I've been saying, I know I'm not allowed to say this word, that the markets are pricing in this transitory oil shock to the front end, and that's kind of normalized as well.

Lawrence Gillum (08:31):

We haven't seen a big move higher in inflation expectations towards the back end. It's interesting to watch oil prices continue to increase, but the back end of the rates market kind of shrugs it off. We still do think that by the end of the year we could get lower rates on the 10-year Treasury yield. We haven't changed our 10-year forecast for 2026, 3.75 to 4.25 is kind of what we expect to see over the back half of the year. That does depend, of course, on the depth and duration of the Iran conflict. The longer this plays out, the less likely we will get interest rate cuts, and that's going to put upward pressure on the 10-year Treasury yield in particular.

Lawrence Gillum (09:20):

And what's also pretty interesting, I liked your comment about zero interest rate policy. I tend to agree that we're probably not getting back there. It took a global pandemic to get there last time. I think we're probably going to have a Fed funds rate above zero. Markets are only pricing in around a 3.5% terminal or neutral Fed funds rate. And so the market doesn't have a lot of confidence the Fed is going to aggressively cut, despite the potential of a Fed chairman changeover to Kevin Warsh. We just got some information last Friday where the Department of Justice is dropping the investigation. The senator from North Carolina, Thom Tillis, has said that he'll now vote to confirm Warsh. So for all intents and purposes, it looks like we will get a new Fed chairman by March, I think it's the 15th or 18th or whatever the date is. And it does mean that Jerome Powell's tenure as chairman of the Federal Reserve is likely coming to an end. So this could be the last press conference we get from Chair Powell this week.

Adam Turnquist (10:35):

Right. And I think there's going to be a lot of theater around this, especially with the administration clearly wanting Chair Powell out. We'll see what happens. I don't know how significantly Warsh can really move the needle on those changes. I know you talked about balance sheet normalization and changing the structure of that, not only in size, but also where the balance sheet is going to be. It was interesting to hear so much talk about AI and it really curing this inflation battle, the idea that AI is kind of solving all of our problems. With the market, it's contributing the most in terms of returns and earnings. Same with our overall GDP, it's contributing more and more, and now it's also solving the inflation problem. Concentration risk, of course. But I think, at least from our view here in research, those secular tailwinds from AI are still in place and will likely be throughout this year.

Lawrence Gillum (11:34):

And I know our Chief Economist, Jeff Roach, has talked about a productivity boom because of the AI story. And that should help with the inflationary dynamics. That's been talked about within the Federal Reserve as well. We'll have to see how that plays out and what that means for Fed communication, which according to Warsh, there's too much of it. I tend to agree on some days, there's just a lot of Fed officials out there talking. One of the things he's talking about is removing all that Fed speak and maybe not even providing forward guidance. I think that could be a little volatility-inducing in some of these fixed income markets. I think there's a concern that we go too far and bring back the Greenspan narrative where people were looking at the size of his briefcase and things like that. But it does seem like this could introduce additional volatility into the rates market.

Adam Turnquist (12:37):

I certainly think they could maybe dial it down a little bit. It would make your job easier, I'm sure, less to review in the commentary, or maybe have a more cohesive communication. I know they're independent and they have their own views, but maybe having a baseline kind of forecast centered around that in terms of the commentary. We do get a lot of differing views, which is good, but from a day-to-day noise perspective, it adds volatility. It would be interesting to see where the market goes if the Fed is removed from the equation in terms of the commentary, and the reliance we have for direction. What's the next signal? Hopefully it's not the briefcase size, but it's certainly going to put more onus on economic data, which tends to be backward-looking. So I don't know if it's necessarily a great thing.

Lawrence Gillum (13:29):

We've talked about this internally, I think there are a lot of proposals that are put forth. And we have that great philosopher Mike Tyson, who likes to say that everyone has a plan until they get punched in the mouth. If there isn't some additional volatility in markets, you'll probably get a Federal Reserve that's coming out and trying to calm markets by providing some forward guidance. But we'll see. I think that and the balance sheet thing you talked about earlier are really the big differences between Jerome Powell and potentially Kevin Warsh. We've talked about this within our investment committee meetings. I think it's going to be a challenge to shrink the balance sheet too much from where it is, they went through the quantitative tightening process recently and had to end it because reserves fell too low. So outside of a change in the regulatory environment, I think we're probably going to have to live with a bloated balance sheet for the foreseeable future.

Adam Turnquist (14:29):

Does that change your view, longer term, on the impact of rates if and when that happens?

Lawrence Gillum (14:40):

I'm actually glad you asked. So I have a lot of models, I don't have a lot of friends, but I have a lot of models for fixed income markets. I was playing around with our term premium model here in LPL Research. There are a couple of big factors that go into this model. Certainly the Fed's ownership of Treasury securities, the makeup or composition of Treasury issuance, stock-bond correlation, that's a big factor, as well as our debt and deficits. And what's interesting is when you think about the term premium, it just represents that additional compensation to own longer-maturity securities.

Lawrence Gillum (15:22):

It was below zero for a long time. It's repriced, we're around 70 basis points now. One of the big drivers of that repricing has been the lack of diversification benefits between stocks and bonds, that's been a big driver. But it also is the makeup or composition of Treasury issuance, because the Federal Reserve holds about 38% of their portfolio in these longer-maturity securities versus, call it 18% of Treasury issuance. That's kept the term premium, and kept the 10-year, call it artificially lower than it should be, at least based upon our model. So to your point, I think if the Fed is involved in the markets and doesn't change the composition of its balance sheet, that probably does keep a ceiling on back-end rates right now. If we used the pre-GFC (Global Financial Crisis) inputs, the Treasury term premium should probably be 50 to 60 basis points higher. So it has had a pretty meaningful impact on the 10-year.

Adam Turnquist (16:39):

I've been, I guess, not surprised by that, but I think a lot of people are surprised when I go do advisor events and client events, you look at, okay, the Fed's been cutting rates since September 2025, I have to flashback here, and yeah, rates are higher. That marked the low in 10-year yields. And that's really when the term premium started to show up and become meaningful, rate cuts were having minimal impact on the long end and really just driving the front end lower.

Lawrence Gillum (17:16):

And to your point from earlier, I think we're kind of in this range for a while until we see some sort of reason why the Fed could cut rates below 3.5%, as we wrote about in our 2026 Outlook publication. The 10-year Treasury yield is highly correlated to the terminal Fed funds rate, and right now it's kind of just stuck at 3.5%. So it's going to take perhaps a disinflationary environment or a crisis for the Fed to cut below that 3.5%. We're probably going to be around these levels for the 10-year Treasury yield, maybe a little bit lower, as we just talked about. But it would take a pretty significant rate-cutting campaign for the right reasons to get the 10-year Treasury yield below 3.75.

Adam Turnquist (18:08):

Right. And lots of auctions this week, not 10-year, but I think we've got twos, fives. I can't remember if sevens are on the auction block this week as well. But I was going to ask about the term premium, has there been an impact of foreign demand? Has that dissipated? That seemed to be a growing narrative really since April, and I know you've written a lot about it. How do you factor that in, whether it's the term premium or just thinking about that indirect bidder participation? Has that really materially moved in line with the headlines that surround it?

Lawrence Gillum (18:50):

No, and it's interesting. It's one of these things where there's a growing narrative about the loss or end of American exceptionalism. I think there's this narrative going on that foreign investors just aren't participating in our markets anymore, and that's just not true. We got some what's called TIC data, Treasury International Capital data, a couple of weeks ago, and it continues to show that there's a lot of interest in Treasury securities, corporate securities, and equities from foreign investors. One of the concerns we had coming into the year, and frankly last year as well, was that higher home rates, because remember, the sell-off in the fixed income market since 2022 has been global.

Lawrence Gillum (19:39):

So we've seen a pretty big move higher in a lot of these domestic government bond markets as well. And typically that means those foreign investors would just keep their money home and invest in their home markets and maybe just not participate in our markets as much as they have in the past. It just hasn't been the case. So we've had pretty strong non-US interest in our markets, which is again another reason it's kept rates lower than perhaps otherwise. But to your point, this will be an interesting week, we have central banks, but we also have, I think, around $180 billion of twos, fives, and sevens coming to market in an environment where auctions have been mixed. So if we had some lousy auctions, we could see some higher yields there.

Lawrence Gillum (20:29):

And that's not just a US thing either. There was a long Gilt auction, the Bank of England sold some debt they owned on their balance sheet, and it was woefully undersubscribed. No one really showed up for that auction. So there's a lot of debt in the markets, a lot of government debt, US, non-US, et cetera, which means yields have moved higher. Let's switch gears and quickly talk about the other central bank meetings: ECB, Bank of England, Bank of Japan. The more interesting of those are the Bank of England and the ECB, they went effectively from rate cuts this year to now rate hikes this year. Anything on a non-US basis that looks interesting? I know we're concerned about the economy, our Chief Economist, Jeffrey Roach, is concerned about their economies and the potential for slow growth or even recession. How are you thinking about those markets?

Adam Turnquist (21:42):

Yeah, we look at those closely, and I think it goes back to relative value and Treasuries potentially losing their relative value. We talked about foreign demand staying strong, and I wonder what the threshold is, with global yields moving higher, they finally hit the point where instead of buying Treasuries at auction, they go to their domestic country, whether it's JGBs or Japanese government bonds. You look at 30-year Bunds, the long bond in Germany is a proxy for Europe, and that's breaking out. I think you can make the case you're going to see a 4% 30-year Bund, highly correlated obviously to the long bond here, the 30-year Treasury. The correlations have come down meaningfully, and you tend to get mean reversion there, where one or the other catches up. But then you look at spreads, I was trying to figure out, okay, Bunds are breaking out, but they're actually very cheap to Treasuries on a very long-term basis.

Adam Turnquist (22:38):

They're trading about 50 basis points cheaper than they have historically. So maybe there is room for Bunds to go higher, but that doesn't mean the long bond here is necessarily going to follow. I think it's maybe just a mean-reversion play, and that is mostly the case internationally. But I do look around the globe, and you can make the case that it's not just Bunds, it's other countries breaking out. Japan's a big buyer of Treasuries, and you have to wonder when that's going to matter. When you look at where the 10-year JGBs are trading, that's a very strong uptrend. Of course, they're trying to normalize their policy, I call it one foot on the gas, one foot on the brake, because you have their fiscal side trying to stimulate while the Bank of Japan is stuck with higher inflation, or above-target inflation, for like 50-some months.

Adam Turnquist (23:31):

I lost track. And they're trying to raise interest rates, I think 0.75% is somewhere around their target rate. It's going to be an interesting year if these trends continue. And when you look at diverging monetary policy paths between the US and the rest of the globe, that's just going to breed volatility in the fixed income market. Traditionally, most central banks are moving in the same direction, maybe not to the same magnitude, but at least directionally, either cutting or hiking. So the US is somewhat of an outlier. The probabilities of hikes and cuts are still, at least with the ECB versus the US, relatively muted. I've been surprised. Speaking of volatility, the MOVE Index, which is the implied volatility in the Treasury market, how much that's come down. You're back to, correct me if I'm wrong, low or near-average implied volatility after a big spike in March. What's the messaging there? Is this the range-bound market?

Lawrence Gillum (24:38):

It is interesting, the MOVE Index spiked at the onset of the Iran conflict, but it's come back down to below-average levels. It's kind of like the equity markets, the credit markets, they're all just not really concerned about a lot. It's one of the reasons why we're not advocating for big positions right now. Historically, when the MOVE Index is falling, you do tend to see this reversion-to-the-mean type event, and you start to see yields move higher and spreads widen, and maybe a negative impact on equity markets as well. So when everything is seemingly this calm, it doesn't make a lot of sense to make big bets, because we do believe in mean reversion in some of these markets.

Lawrence Gillum (25:28):

And we could get that event, which would be a better buying opportunity in our view, either to add duration or to add credit to portfolios. Speaking quickly about credit spreads, we saw both investment-grade and high-yield spreads widen out a little bit at the start of the Iran conflict. But now they're back to secular tights or close to secular tights. The investment-grade corporate bond spread above Treasuries, I think, is in the third percentile since 2001, they've been higher 97% of the time. It just doesn't seem like there's a lot of concern out of a lot of these markets these days.

Adam Turnquist (26:07):

Basically hit the snooze button after the start of the war. I was surprised looking longer term at whether it's investment-grade or high-yield spreads, comparing them to 2025. We had a similar escalation with the tariff shock and the de-escalation with the tariff pause, but credit spreads got nowhere near the levels they did in 2025. Certainly not like the bear market in 2022, where credit, I don't know if you'd say it was blown out, but materially higher, probably more in line with average compared to where we're trading now. And to your point, we're breaking out on the high-yield space following equities higher. We view that as one of the constructive signals for this equity market rally being more durable when you have credit agreeing with the equity market. And I think that's certainly the case right now.

Lawrence Gillum (26:57):

We'll have to see what, if anything, will wake up the credit markets. There's been a big buyer of yield in these markets. As yields have moved higher throughout the rate-hiking campaign from '22 and '23, we've seen a lot of institutional investors come in who don't really care about spread, they've just been buying bonds with high yields and holding to maturity. And that's been keeping spreads, in our view, arguably too tight for the risks out there.

Adam Turnquist (27:26):

I was going to bring up private credit, if that's going to be a material concern, can that spill over? Is that going to be the catalyst you'll see in credit spreads? Or is this just more idiosyncratic risk with that market?

Lawrence Gillum (27:43):

It's a great point. We've been talking and writing a lot about private credit. There's a lot of noise out there. But if there is any sort of spillover into the public markets, you would see it through higher spreads. A lot of these managers own not only private credit, but also bank loans and high-yield debt as well. And bank loans and high-yield debt are the more liquid of those three categories. So if you do see a situation where managers need to sell something they can sell, it'll be the more liquid parts of their book, and that could push spreads wider. But again, we haven't seen that yet. That's an area we continue to watch in private credit. Most of the concerns are around the AI software issues. We have some of that exposure in the bank loan market, but if you look at high-yield or investment-grade corporate credit markets, they're pretty insulated from that kind of thing. So we haven't seen any risks yet, but we're paying attention to it.

Adam Turnquist (28:48):

We've certainly been watching the software sub-industry group technically as well. We're checking a lot of boxes on a potential bottom there. There's volatility, we don't think it's going to be V-shaped given the narrative of this disruption, but not making any new lows, volume's been pretty constructive. We're starting to see bidders come in right at a major support level. So I think we'll call it an important step in the right direction, far from waving the all-clear here, but I certainly think there's evidence now that maybe the lows were set last month. We'll continue to monitor that on the equity side as well.

Lawrence Gillum (29:22):

All right, Adam, we've talked central banks, rates, credit spreads, and private credit. What else is on your radar this week?

Adam Turnquist (29:31):

Oil markets, of course, a big one that's really been the driver of risk appetite, a little bit less so lately. The market seems pretty complacent with the war in Iran ending at some point with minimal knock-on effects. That's a big question mark. When you look at the supply chain being shut down through the Strait of Hormuz, oil with Brent above $98, that's concerning. I'm really watching the Brent forward market, looking at where contracts, for example, in November and December, are trading to get an idea of what the market's telling us about the latest news coming out of Iran. We haven't had a major repricing in forward-dated Brent contracts. So we know the supply shock is present, with the Brent curve in backwardation, those front-month contracts are very expensive, much more so than November and December.

Adam Turnquist (30:28):

But really watching for any type of reaction on the longer-dated Brent contracts, I think that would be more concerning to the market, shifting back to a higher-for-longer oil regime. Haven't really seen it. There's been some reaction, but for the most part, the curve has started to compress on those longer-dated contracts. I think that's a good sign overall. And of course, earnings are going to be big this week. We'll get a lot of names out. So far that narrative has really married well with the technicals, really strong earnings growth, the market breaking out, tech back in leadership. So I think we're more or less firing on all cylinders, absent the geopolitical risk. That's again a big question mark.

Lawrence Gillum (31:10):

That continues to be the big question mark for rates markets and fixed income markets too, just the depth and duration of what's going on in the Middle East. But with that, I think we can wrap. Just as a key takeaway: within the fixed income markets, spreads are too tight within the corporate credit markets to really get excited about those markets. We think we're in a higher-for-longer interest rate environment. We're not doing anything as it relates to duration within our portfolios, the interest rate sensitivity, relative to indexes. We think staying neutral right now and looking for that fatter pitch is the right call. More volatility in the rates market and more volatility in the credit markets will hopefully allow us to find some opportunities to add to those positions. But with that, thanks, Adam, for joining me today. Really appreciate the insights. We will be back next week, same time, same channel. Hopefully you guys can check us out.