The US economy grew by 2.3% per annum in the 12 months to 30 June 2015, according to estimates of Q2 2015 GDP released last night. Markets were expecting 2.5% to 3.0% p.a. and FIIG had expected 2.4% p.a.
What was more interesting in the release was the inflation data. There are two points of data looked at by the US Federal Reserve (the “Fed”, its central bank). Firstly, year over year inflation, which is a measure of the average prices in the 12 months to 30 June 2015 compared to the average prices in the 12 months to 30 June 2014. And, quarter over quarter, which is a measure of the average prices in the three months to 30 June 2015 compared to average prices in the three months to 30 June 2014.
To recap, the Fed cares about inflation as its job is to maximise employment while maintaining inflation that is not in excess of 2% p.a. It will leave rates low until inflation starts to approach the 2.0% p.a. target.
The year over year measure is more stable and therefore carries more weight with the Fed. The year over year measure was 1.3% p.a., still a long way below the Fed’s target. The quarter over quarter figure was 1.8% p.a.
Markets were excited over the quarter over quarter data. While the low GDP data caused 10 year and 30 year bonds to fall in yield (increase in price), the 5 year and shorter bonds increased in yield. This indicates markets believe that rates will go up sooner, but not go up as much as they believed the day before.
We believe that the markets have over reacted by looking at the volatile quarter over quarter inflation data instead of the more reliable year over year data.
We stand by our expectation that the Fed will increase rates this year, probably December, but that the cycle of rate rises into 2016 will be slower and shorter than markets are pricing in. Therefore, we hold the view, that yields on bonds from 5 years and longer are currently good value. With the jump in the 5 year last night, there is likely to be particularly good value with bonds maturing around the 2018 to 2023 period. Longer dated bonds remain good value.