Short-term spreads inverted — Is this a concern for 2019?
The yield curve has inverted in the two- to five-year range. In market terms, this means that a U.S. treasury maturing in five years yields less than a U.S. treasury maturing in two years. In everyday terms, this means that investors are worried about the U.S. macroeconomic outlook over the next few years. However, for now, the two- to ten-year spread is still in positive territory—although it has flattened to 15 basis points.
U.S. Treasury Yield Curve Steepness
Jan 1980 – Dec 2018
Source: Thompson Reuters Datastream. As of 12/4/18.
It’s important to note that inversion does not signal immediate trouble. The two- to five-year spread last inverted on December 14, 2005, years before the next recession and 28% additional return before equity markets peaked. That said, inversion clearly signals a late-cycle economy. The market expects slower growth and lower inflation. We think this is the market’s way of saying the economy has more room to run, but that the Fed should not exceed a 3.0% Fed Funds rate in this tightening cycle.
Last week, Federal Reserve statements showed that policymakers are already considering a slowdown in rates hikes. Policy works on a lag, and higher interest rates are showing early signs of biting in the real economy. Homebuilder sentiment, consumer durables, and mortgage applications, while far from worrisome, are losing steam. The economy is doing well, the Fed said, but they will pay close attention to when they should slow their pace of rate hikes.
The Fed also realizes that the risks of its policymaking are skewed. Upside risks are limited, for the most part, to the potential for a tight labor market to drive higher inflation. The downside risks – slowing economic growth in the U.S. and abroad, uncertainty surrounding the U.S. debt ceiling in 2019, and geopolitical disruptions – are much more plentiful. Perhaps most importantly, hiking rates too fast has greater risk than hiking too slowly.
We think the Federal Reserve will increase the Fed Funds Rate by 0.25% in December, but that it will signal a slowing pace to its rate hikes in the first half of next year. The U.S. economy has been growing strongly, driving rate hikes to this point. But policy works on a lag, and higher interest rates are showing early signs of biting in the real economy. Homebuilder sentiment, consumer durables, and mortgage applications, while far from worrisome, are losing steam. Our view on the Fed is a key driver of our market outlook for 2019, and for our portfolios:
- Prepare for a bumpy ride. Data dependence works both ways. While risks to interest rates are shifting to the downside, an upside surprise in economic activity could still take place. For example, consistently stronger wage data or a substantial tax rebate-driven boost to consumer spending could prompt the Fed to raise interest rates more quickly. Ultimately, weaker forward guidance will introduce uncertainty around the pace of interest rate hikes, prompting higher volatility around important data releases.
- Interest rate policy is the most important driver of dollar assets. Value of the dollar is an important driver of financial markets – and even economic growth – outside of the United States. Lower expectations for the U.S. interest rate trajectory contributes to a weaker dollar and generally support commodities prices and emerging markets currencies. If future Fed guidance gives markets a reason to believe that rates rises will accelerate, the dollar will strengthen, all else equal.
- Duration is difficult. At this stage in the economic cycle, and with increased uncertainty around the future level of short-term rates, we prefer short duration fixed income opportunities in our portfolios.
- Fed activity will play a strong role in regional out-performance. 2018 was a story of divergence: U.S. economic out-performance prompted a stronger dollar and higher U.S. asset prices relative to international and emerging markets. We expect that U.S. growth will remain strong next year but will likely slow. We also expect that key risks to the international environment – trade wars, Italy fears, and Brexit – will be relieved next year and should relieve price pressures on ex-U.S. markets.
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A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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