by Hubert Marleau, Market Economist, Palos Management
The bond market has not made the front pages in the past few weeks. Yet, the yield on ten-year Treasuries increased from a low of 1.45% registered on August 28 to 1.80% on Friday.
The bond narrative of 2019 was that the bond market was proactively pricing dire economic outcomes. As it turns out, the economy is apparently only slowing down. Except for inventories and international trade, all of the big data pieces of the third quarter GDP puzzle are out.
High frequency economic models which are based on streaming data points are showing growth estimates ranging from 1.8% (Atlanta Fed) to 1.2% (Moody’s Analytics).
Barclay’s forecast is 1.5% and Macroeconomic Advisor is predicting 1.5%. Consequently, recent actions in the bond market have been more of a story of right-sizing economic expectations.
As it currently stands, the yield curve is upward sloping, reflecting greater risk tolerance, lowering concerns for recessionary conditions and the implied 95% probability of a 25bps cut in the federal funds rate at the next October 30 FOMC meeting.
Investors should note that the latest yield curve inversion of at least 10 bps may have lasted for fewer than five months, the shortest inversion since the 4-month one in 1998.
History shows that it takes between nine and nineteen months of continuous inversion to produce a recession. It is reasonable to suppose that the speedy action by the Fed in cutting interest rates may have helped avoid a possible contraction in the level of economic activity and help in keeping a recession away.
Despite the selloff in the treasury markets with uncertainties abounding, financial stress is near the lowest point in 20 years. The St. Louis Fed Financial Stress Index is presently -1.22. It was +5.50 just before the Great Recession (GR) and averaging around +0.50 in the decade leading to the GR.
Unsurprisingly, the N.Y. Fed ( a financial model) is giving a 34% chance of a recession in the next 12 months. That is much less than it was last month. Morgan Stanley’s recession probability model which uses financial and economic data, has also turned lower to only 10.6%. What we saw this last week was a peeking of recession fears, a bottoming of bond yields, a continuation of moderate but steady growth and as a result a rebound in global equities.
While I am aware that the modern volatility regime makes non-recessionary bear markets possible, economic history shows that when valuations are low or normal, contractions are mild, recessionary conditions are concentrated in a few industries, monetary policy preempts possible outcomes or a timely increase in the money supply occurs, bear markets are more often than not avoided.
It is why active portfolio managers have slowly but gradually rotated toward cyclical and/or value stocks whose pricing power nudges up and fares well when inflation rises.
While these economic and financial improvements have lent a hand to return the yield curve to normalcy, it may be even steeper at the end of next week. The Fed is likely to announce a third rate cut in a row. And, the Fed should because it is what the market wants as depressed global economic activity is widespread and uncertainties could become contagious.
Academically, the Fed’s policy rate is about 25 bps higher than the neutral rate--a rate that is neither cold nor hot for the economy. A federal funds rate ranging between 1.50% and 1.75% would be like room temperature. Friday’s federal funds futures contracts were right on at mid-point--1.63%.
However, the Palos Monetary Policy Index, which takes into account inflation, employment, growth and the viability of the balance of payments, is stabilizing. It suggests that the Federal Reserve may signal that the current easing cycle could be over after the expected rate cut on Wednesday. In other words, the mid-cycle adjustment to which Chairman Powell alluded might be tweaked to reflect Fed’s belief that the economy is solid enough to perform on its own form hereon.
There are two Fed Presidents-Kansas City and Boston who strongly prefer to let interest rates rest where they are, making the point that the Fed and other central banks have cut rates at an even faster clip than the trend in realized inflation dictates. Transactional money with zero maturity and immediately available to spend (MZM) has accelerated throughout 2019 to attain yearly increase of 6.9% considerably more than the path of N-GDP.
Given the loose but measurable link between the money supply and inflation, unsurprisingly a noticeable increase in inflationary expectations has been registered in the bond market as well as the stock market.
While I do not expect the FOMC to directly address the Fed’s recent actions in the overnight repo markets because it is not related to monetary policy per se, it remains that it is a form of quantitative easing. It may be premature to celebrate the restoration of a normal upward sloping yield curve.
But, investors should not forget that the new Fed program of buying treasury bills to prevent a repeat of the cash crunch that sent lending rates spiralling in September will expand the Fed’s balance sheet as reserves gets back to the $1.5 tn level. According to Oxford Economics, the Fed will probably end up with 12% of the market for US T-B’s.
That alone could keep the curve positive. Given the scale of the Fed’s bill-buying programme, any unwillingness on the part of banks to hold on to their treasury bills could bring lower short-term interest rates.
This is why it may not be necessary for the Fed to go beyond three rate cuts. This possible shortfall has not cropped up to date as there have been enough sellers to meet what the Fed has been willing to buy. But, that could change. Surely, the Fed is aware of this possibility.
P.S. The Bank of Canada, the least dovish central bank in the developed countries, is expected to keep on resisting looser monetary policy.
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