The Fed and the markets are learning how to communicate; parts of the U.S. yield curve are steepening; Brexit's impact on currencies and asset prices follows its own logic.
U.S. Rates: Calmer Year Ahead for the Fed?
It’s taken several months for Fed Chair Powell and other members of the Open Market Committee to find the right balance in communicating their intentions to financial markets—and to figure out what they intend to say— given the disconnect between the Fed’s formerly rosy view of the future and a more guarded view held by many investors.
As Western Asset’s John Bellows points out in Fed Outlook for 2019: “Wait and See” the broadly held belief that the Fed would raise rates up to three times in 2019 looks to have peaked in early November – based on futures contracts for the Fed’s overnight rate.
Now, with the economy nearing the Fed’s goals in terms of employment and inflation, the central bank faces a different challenge; how to gracefully transition to their now more cautious outlook.
A Round Trip for Market Consensus on the Fed’s Next Moves
Overnignt Interest Rates, 2-Year Forward
Chart courtesy of Western Asset Management. Source: Bureau of Labor Statistics as of 4 January 2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Front and center in market calculations are signals that growth could be slowing, making it far less likely that inflation will rise into the Fed’s 2% target range for core PCE inflation. As Western notes, meeting that challenge may require that the FOMC forego rate hikes this year.
Market observers will have more opportunities to question Chair Powell than in previous years, with press conferences after each of the FOMC’s ten meetings, rather than just one per quarter. Whether this new communications tactic will foster greater harmony remains to be seen.
On the rise: Steepening in U.S. Treasury Curve
By at least one closely-followed measure, the yield curve for U.S. Treasuries is steepening noticeably. After hitting its 2018 low of about 19.75 basis points (bps) in mid-July, the spread between the 5- and 30-year rose as high as 56.4 bps on Tuesday – a level not seen since almost a year ago. The 10- to 30-year spread is on a similar path, having risen to 35.7 bps, the highest level in over a year.
These moves suggest that recession-focused curve-watchers might want to relax a bit. But the shorter end of the curve is still flattening, with yields for maturities between 2 and 5 years continuing to slope downward for now. While the markets for shorter-dated maturities is driven by different forces – including increased Treasury auction activity as the US ups its borrowing – it’s too early to declare the recession watch over.
On the slide: Major Currencies other than the British Pound.
Tuesday’s defeat of Prime Minister Theresa May’s hard-fought Brexit deal with the EU had a paradoxically positive impact on the pound’s value. It rose some 0.64% on the day vs. the euro to about €1.129 before pulling back slightly. The pound even rose 0.74% against the Swiss franc on the day and was up some 1.5% against the franc year to date – notable given the Swiss currency’s role as the continent’s default local safe haven during volatile markets. Prime Minister May’s widely-expected defeat took place after trading hours for European equities.
The lack of clarity on what happens next makes whether-or-not predictions particularly challenging – one possible reason that financial market reactions have been relatively muted so far.
All data Source: Bloomberg, January 15, 2019 unless otherwise noted
Definitions:
The Federal Open Market Committee (FOMC) is the main policymaking body of the Federal Reserve Board (“Fed”), which is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The term forward rate is commonly used in both bond and currency trading to express today's expectation of the future value of either a currency or a bond. In bond trading the forward rate is an implied rate calculated from current interest rates on various bond maturities.
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
A spread is the difference in yield between two different types of fixed income securities with similar maturities
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities
One basis point equals 1/100 percentage point; 100 basis points equals one percentage point.
