Nick Maroutsos, Co-Head of Global Bonds, explains why the US Federal Reserve (Fed) will likely not meet its 2019 interest rate target and how investors might position themselves for a more subdued rate path.
Until the summer of 2018, bond investors expected 2019 to be characterised by a continuation of gradual rate tightening by the Federal Reserve (Fed) and an upward shift along the front end of the US Treasury yield curve. Fiscal stimulus and strong economic data stood to push the yield on 10-year Treasuries above 3.0% for the first time since 2014. This scenario was reinforced by wages registering annual gains greater than 3.0% and Fed Chair Jerome Powell’s comment that interest rates were “a long way from neutral”, meaning markets could expect additional hikes. Spurred by these developments, rates rose across the curve during the autumn. It was not to last.
The late-year reversal in Treasuries and widening of credit spreads indicate that the market’s expectations for 2019 have changed considerably. While many factors have contributed to falling yields and a flattening curve, we consider the focal point to be the Fed’s expected interest rate path.
Plan A – out the window?
Investors expected higher interest rates for several reasons. Foremost, the Fed told us. The rationale behind forward guidance was to telegraph the future path of rates so as not to surprise markets. Many believed the Fed sought to increase its “dry powder” to better prepare itself for an economic downturn. Economic data also favoured continued tightening. US GDP growth for 2018 is forecast to reach 3.0%, driven by solid consumption and business investment. The uptick in wages reminded the Fed to be vigilant about inflation. Lastly, the extended business cycle led to rich valuations in risk assets such as stocks and corporate credits and deteriorating credit standards, developments the Fed could interpret as signs of an overheating economy.
With the labour market at what many view as full employment, the need to keep rates low has dissipated. However, given the lack of inflation, there is scant reason to push forward on aggressive tightening. In fact, we believe that disinflationary forces have recently gathered steam. After reaching the Fed’s targeted level, core inflation has slid back below 2.0%, and annualised monthly data indicate this downward trend is accelerating. Should crude oil’s 30% late-year drop prove sticky, lower prices could leech into core inflation and could send the Fed’s favoured price gauge even lower.
Chart 1: Core PCE Index, three-month change annualised
Source: Bloomberg, as at December 2018. PCE = personal consumption expenditures.
While lower oil prices benefit many industries, drilling’s increasing role in the US economy could add a headwind to future growth prospects. But overshadowing the risk posed by oil are the trade disputes that have fuelled caution among companies as the future playing field of global commerce remains uncertain. This ambiguity has acutely weighed on China and the countries that are heavily intertwined in its supply chain.
Many of the autumn’s developments – from higher longer-dated Treasuries to a wobbly stock market – act as a form of fiscal tightening and, thus, may diminish the need for the Fed to maintain its recent pace. Furthermore, the Fed’s bias remains dovish, meaning that if it were to risk policy error, it would be to allow the economy to run hot for a finite period. It is our view that the risk posed by slowing rate hikes has diminished as the economy is arguably positioned for a sustained period of non-inflationary growth.
Where to go
For much of the past two years, we considered holding US duration a risky proposition given the Fed’s removal of accommodative monetary policy vis-à-vis its developed market peers. In light of the widening range of outcomes for the global economy and the absence of inflation, we believe the 2019 prospects for Treasuries may not be as grim as originally expected. Should a slowdown in global growth occur or one of many potential sources of geopolitical risk ignite, Treasuries’ allure may further rise as investors seek traditional safe havens.
If investors choose to increase their Treasuries allocation, they still must be selective as to which tenors to target. The yield curve flattened significantly in 2018, with the spread between 10-year and 2-year notes sliding from 78 basis points (bps) in February to less than 12 bps by early December. Such a term structure provides investors little incremental return for the additional interest rate risk they take on when holding longer-dated securities. For this reason, we expect any push into Treasuries to be concentrated along the front end of the curve.
The return of an asset class
As recently as 2017, the appeal of holding shorter-dated Treasuries may have been limited given their low yields. That is no longer the case. The Fed’s nine rate increases pushed the yield on the 2-year note toward 3.0% before the late 2018 reversal in yields, up from 0.55% in 2016. Higher yields have buttressed the argument for shorter-dated bonds being their own asset class rather than a proxy for cash they were viewed as for much of the post-crisis era. Should the pace of rate hikes be curtailed, we consider it more likely that the yield curve experiences some steepening in 2019 as investors seek the stability – and yield – of shorter-dated Treasuries.
Conversely, a move into Treasuries would come at the expense of foreign bonds. We are, however, not there yet. Many regions lag the US in tightening, and a slowdown in global growth is likely to keep their policy accommodative for longer. Given their reliance on commodities and linkages to China, Australia and New Zealand fit into this category. These countries still offer attractive carry relative to the US, but increasing dovishness by the Fed may justify an eventual equal-weighting to US duration.
European sovereigns, with their low yields, are less desirable. The situation is exacerbated by the acute risk the region faces with Brexit, Italy’s budget stand-off and a leadership transition in Germany. While we do not expect the European Central Bank to institute another round of quantitative easing, we believe it will hold off on tightening until the outlook becomes clearer.
Futures markets expect only one rate hike in 2019 and none in 2020, well below the Fed’s median forecast. Should the market be proven correct, investors would likely have to deal with a weaker-than-expected economy. Low-growth conditions would not be favourable for overburdened corporate balance sheets and the ensuing spread widening would add yet another reason for investors to seek the safe harbour of Treasuries.
Should the Fed’s view be right, the market would likely experience a snapback, much like what was experienced in October when yields rose across the curve. While not our base-case scenario, we believe the higher rate path could be driven by an upside surprise in inflation, either due to robust wage growth or tariffs resulting in higher-priced goods for US consumers.