Twelve months ago the main concern for markets was what a US Federal Reserve, with Jay Powell as its newly appointed chair, might do with respect to US rates throughout 2018.
Expectations of a US fiscal boost, which had been a constant speculation since President Trump’s inauguration, finally came to fruition in the wake of a raft of tax cuts in January. These helped give the US economy a significant boost, culminating in a Q2 GDP print of 4.2% in the summer.
Wage growth is also seeing signs of a steady lift, along with headline inflation, which saw a peak of 2.9% in the middle of the summer driven largely by a significant rise in the oil price.
As a result of this stimulus, the Federal Reserve followed up its three rate rises in 2017 with another three this year. There’s the potential for a fourth this month on the 19 December.
These increases, along with a slow reduction of its balance sheet, have given rise to a stronger US dollar which in turn has fired expectations of further US rate rises to levels that were having significantly damaging effects on not only emerging market economies, but on large holders of US dollar denominated loans.
The strong surge in the US economy also contrived to disguise what was an initially imperceptible, but slowly growing realisation, that the global economy was starting to show signs of slowing. This was something that did appear to have been accelerated by a rise in oil prices to four-year peaks in October of $85 a barrel.
Since then the wheels have started to come off the wagon, with all of the early gains for stock markets in the first half of 2018 slowly getting unwound.
Furthermore, inflation expectations have also started to diminish, helped in some part by the over 30% decline in oil prices since the peaks in October.
This has once again raised the prospect of what we saw at the end of last year – a flattening yield curve when US short-term rates rise to meet US longer-term rates – flattening out the differences between the different time frames.
In a normal scenario, bond yields tend to rise gradually the further out you go, and this upward gradient (called a rising yield curve) is an indicator that investors think the economy is operating without too many stresses.
If this behaviour starts to change and you get a flattening of rates, followed by an inversion where long-term rates fall below short-term rates, that tends to be viewed as a negative sign that economic conditions are starting to deteriorate and a recession is on its way, and that longer-term inflationary pressures are likely to remain subdued.
As can be seen from the graph below, 2018 got off to a fairly decent start as yield differentials (green line) widened out. However, since the sharp sell-off in equity markets seen in early February and in the wake of the tax cuts announcement, yield differentials have slid back sharply, heading towards zero, with the potential to invert. This probably reflects a concern that the Federal Reserve might over tighten.
With 10-year yields now back well below 3%, it is hard to imagine that in October we were above 3.2% with the prospect of a move even higher. The fact that hasn’t transpired doesn’t mean it won’t in the longer term, but in the short term it looks less likely to happen in the next 12 months or so. If anything, the calculus has shifted for a move back towards 2.75% where the two-year yield currently sits.
This narrowing or inversion in the case of the five-year yield – which has already fallen below the two-year yield – raises important questions about not only the direction of Fed policy, but also how bond markets perceive where the US economy is heading over the next year or so.
It also suggests that markets not only appear to be pricing in a slowdown in economic activity, but also a significantly more long-term benign inflation environment, which could have significant implications for future Fed policy. It could arguably mean that next year we might see the Fed come under pressure to cut rates.
It is widely expected that the Fed will raise rates in December for the fourth time this year, while markets are still pricing in further tightening in 2019. This seems rather at odds to what the graph above is telling us and Fed policymakers at some point will need to reflect this, and ask should we be actually looking to do this.
We’ve already seen some evidence that Fed policymakers are starting to dial back expectations of further aggressive tightening next year.
An inversion of the 10s/2s curve will in all likelihood dial back those expectations further and could invite speculation that any move in rates in 2019 could be in the form of a rate cut, as opposed to a rate hike.
Since the end of World War Two the US yield curve has inverted on eight occasions, and each time this inversion has been followed by a recession. Is it probable that the Federal Reserve will tighten further in 2019 when faced with this type of scenario?
Against that backdrop we could start to see markets pricing in a US rate cut towards the end of 2019.
Looking at inflation expectations elsewhere, we’ve also seen some weakness in recent weeks. Though unlike the US, where they are still higher now than they were a year ago, there hasn’t been much movement.
10-year bund yields are lower now than when they started the year, despite a European Central Bank that has been steadily reducing its stimulus throughout the course of the year. They reached a peak of 0.767% in February this year on expectations that the solid economic growth seen in 2017 would continue into 2018. This was always an optimistic view and the European Central Bank will in all likelihood have to dial back its guidance of a rate rise towards the end of 2019, though it will merely confirm what bond markets are already pricing in.
UK gilt yields have done slightly better, marginally higher than 12 months ago but, like bunds, also well down from their peaks in October at 1.71%, despite one rate rise this year.
Bond market inflation expectations of all the major bond benchmarks have had a mixed year. The US five-year outlook is not too dissimilar to the levels we saw this time last year. However, German inflation expectations have slid by eight basis points, while UK expectations have risen 20 points, possibly as a result of a weaker pound.
As we look ahead to next year, this raises important questions about the direction of central bank policy. While most of this year has been given over to how much central banks will continue to pull back, the direction of travel when it comes to the yield curve would suggest that any further tightening seems highly unlikely.
Much will depend on expectations surrounding monetary policy and while markets may still be expecting US rates to rise further, this could well start to get priced out in the weeks and months ahead. This will no doubt please President Trump, though he will likely blame any resultant slowdown and any stock market losses on this years Fed rate hikes.
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