U.S. Rate Policy: All Clear?

Mid Week Bond Update

U.S. Rate Policy: All Clear?

As the Fed's policies stabilize, markets appear to be calming down; Treasury term spreads are widening above 5-year maturities, but for different reasons at different intervals; China's government bond yields reflect the current policies of promoting growth.



U.S. Rate Policy: All Clear?

It’s been an up-and-down year for Fed Chair Powell, whose clarity of communications has been a mixed blessing. Each change of direction in Fed policy was stated clearly, but there were enough of them to increase uncertainty in financial markets about how to price stocks and bonds, and in corporations about how to budget for future capital investment.

One place to observe the confusion has been in the futures market, where it's possible to buy and sell contracts based on what the Fed's overnight rates will be at specified dates in the future -- which can be read as short-term forecasts of what the Fed will do with its benchmark rate.

The year 2018 was a case in point. At the beginning of the year, market participants expected little movement in the Fed's target rate. But as growth figures came in during the year, speculation rose that the rate would be hiked to forestall what was believed to be the inevitable inflation that lay ahead. By September, it was widely believed that there would be as many as three hikes in 2019.  But consensus rapidly shifted downward, to the point that the current debate among market participants is whether rates will be raised at all, or even lowered.

As John Bellows wrote in Western Asset's Fed Outlook: "Wait and See", when all was said and done, 2-year futures for the Fed's overnight rate ended 2018 roughly where they began, as shown in the accompanying chart.
 

The Futures Market Voted on Overnight Rates

Original chart courtesy of Western Asset. Source: Bloomberg, as of Feb 15, 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.

 

Since then, expectations seem to have coalesced; two-year Fed Funds overnight futures two years out are pricing in very little net change in the Fed's upper bound target rate.

Because futures markets change their net views of the future on a second-by-second basis, the above glimpse two years from now is unlikely to stand.  But the picture it draws lines up well with the changing course of Fed policy in 2018.
 

On the rise: Treasury term spreads, 5 years and above  

What's behind the steady steepening of the yield curve for U.S. Treasuries between 5 and 30 years since September 2018?

As of February 26, the 5 year – 30 year (5y30) spread stood at 56.0 basis points (bps) and the 10y30 at 36.86 bps1. The rise had two phases: 30-year yields rose sharply between the end of August and the beginning of November. Then, between November and mid-February, there was an additional notable rise in steepness – the result of a downward race between 5- and 10-year Treasuries, both of which fell more than the 30-year during that period.

The first phase was about the anticipation of rapid economic growth, pushing 30-year yields upward.  The second phase was more about how the Fed would react as that growth unfolded.

But most important, the shift was most definitely not about steadily rising expectations about inflation and growth; in fact, inflation appears to be increasingly difficult to find throughout the world.  For more on the implications of a low-inflation world, read Western Asset's article: A Long Leash for Central Banks.
 

On the slide: Yields on China Government Bonds

China's current pro-growth policies are having a clear effect on its bond market.  The yield on China's 10-year government bond (denominated in yuan) hit a 5-year peak of 4.03% on November 22, 2017; since then, the yield has reached as low as 3.07% on February 12, and now stands at 3.19%2.

One of the most powerful sources of liquidity in China comes from its banks.  The rapid reduction of major banks' required deposit reserve ratio (RRR) since the beginning of 2018, from 17.0% to the current 13.5%, is expected to encourage lending, especially in property (i.e., real estate). At the  height of China's policy to restrain growth in 2011, RRR was set as high as 21.5% (6/20/2011).


All data Source: Bloomberg as of February 26, 2019 unless otherwise specified.

 

1 Source: Bloomberg, February 26, 2019, 3:18 PM ET

2 Source: Bloomberg, February 26, 2019, 4:07 PM ET

 

Definitions:

The term forward rate is commonly used in both bond and currency trading to express today's expectation of the future value of a currency, a bond, or an interest rate at specified future dates. The term "forwards" often refers to the value of futures contracts at specified datews or intervals.

The Federal Reserve (Fed) system is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

spread is the difference in yield between two different types of fixed income securities with similar maturities, or similar bonds with different maturities. "Term spread" specifically refers to the difference in yields between two bonds of the same type but with different maturities. 

basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).

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