David Roberts

Fed entering the danger zone

David Roberts

US Federal Reserve

The US Federal Reserve’s much-maligned “dot plot” chart, released on Tuesday, signalled the central bank does not expect to raise interest rates this year, which came as a (small) surprise to investors. Immediate market reaction was “risk positive”; actually, it was “everything positive”, except perhaps for the US dollar, which fell.

Our view remains that interest rate policy, globally, is a little too relaxed for current economic conditions. However, central banks have correctly decided to wait to ensure the soft patch in the fourth quarter of 2018 does not extend into this year. They were encouraged in this when equity markets plunged in December and I believe it was a mistake for policymakers to be so transparent. 

Data have improved and if this continues and we see some positive resolution on Brexit and trade, then I think US rates should rise later this year. Whether they will, however, is less certain and is where the Fed may be entering dangerous territory.

Turning to bond prices, too much bad news is priced in and the market now expects a rate cut in the US this year, just a few months removed from predicting at least two rises. Euro and UK rates lock investors into negative real returns, something that makes no sense and defies 500 years of bond market history.

Now, I don’t want to be a scaremonger. Those who have followed me over the past year know I watch the US interest rate curve closely. Many people will tell you the relationship between short and long-dated bonds can predict a recession and when the curve “flattens” (long bonds doing better than short-dated) that is a bad sign. My view has always been that we do not need to worry until the curve starts to steepen after a period of flattening, with long-dated bonds underperforming short-dated. Often, recession occurs nine to 12 months after the curve starts to steepen.

Steepening US yield curve (yield spread between five and 30-year bonds)

David Roberts: Fed entering the  danger zone

Source: Bloomberg, at 21.03.19

The bad news: the US rate curve has been steepening for some time, actually about nine months. The difference in yield between five and 30-year maturity bonds, as the chart shows, has risen from 0.2% to 0.64%. This isn’t much by historic standards but enough to get the bond vigilantes excited.

Normally, the curve steepens because the market expects more rate hikes will come, choking off growth and helping “create” recession. We would note here that recessions are not normally evil and frequently allow an overheated economy some breathing space and prevent a bigger bust: the global financial crisis was so bad because everything had been stoked up in advance, whereas we should have had a slowdown two or three years earlier to mitigate excess.

We would typically expect to see a bear steepener, where long yields rise and place a burden on borrowers. So far however, it has been a bull steepener, where bond prices have risen and short yields fallen, making borrowing cheaper and helping support growth. This is good short term but less so medium term and the bond market is telling us we are entering danger zone territory.

US central bankers (as they have previously told us) are prepared to risk inflation and excess growth, which should support risk assets. However, if and it is a big if growth and inflation get out of control and asset bubbles emerge, central banks will have to act more aggressively than would otherwise be the case.

To a degree, that is what happened in 2008 and this is what the bond market is worried about  which is why the interest rate curve is steepening. The bond market is saying it wants a greater premium for long bonds relative to shorter-dated to compensate for the risk the Fed may have to do more, and logically the longer you delay normalising policy, the greater the risk you need to do more at a later stage.

There is a “however” here though: namely, why has this not been the case in Japan or Europe? Japan, I would say, has been a special case, with bad demographics and a population happy to buy bonds below inflation for the social good.

With Europe, it is still too early to say as low rates are distorting euro markets, forcing Germany to run a budget surplus. Despite rumours to the contrary, however, inflation especially in core Europe – is actually quite strong, close to European Central Bank targets and 20-year averages.  

If the Fed is forced to act to curb excess and tighten too much, then we can hit recession, potentially a necessary evil to correct system imbalances. This, for me, is where the predictive power of the interest rate curve really lies.

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Thursday, March 21, 2019, 4:37 PM