The U.S. Treasury yield curve, as measured by the difference between the 2-year and 10-year bonds inverted at the end of August only to steepen sharply at the beginning of September before collapsing post the FOMC meeting and is re-steepening again as economic data has shown signs of weakness across both manufacturing and services. Just as trick-or-treaters seek out the house offering full size candy bars and avoid the one offering raisins, traders may want to consider the possibility for the October meeting to be either a trick or a treat as the potential for both positive and negative outcomes has increased.
More Cuts to Come?
FOMC members continue to emphasize that the most recent cuts are a mid-cycle adjustment as in 1995 and 1998, but the business cycle may not allow them to do only that, as the outlook for the longest running US expansion continues to face headwinds from the lingering impact of Chinese deleveraging and structural challenges in the Eurozone, to more topical ones like the ongoing trade negotiations and Brexit.
Slow Growth. Low Inflation.
For now, the US economy is still growing, but that growth is slowing; however, it is not yet so poor that job growth has seen major impact. What may be more concerning is inflation expectations. For some time, inflation has not moved as expected likely for structural reasons, making investors not require compensation for the risk of capital loss thanks to rising prices. This has been reflected as a persistently negative term premium. Simply put, a negative term premium means that investors are not requiring excess yield to hold longer-term debt as opposed to rolling over shorter-term debt. In addition, the tariffs are proving disinflationary as they move to a wider range of industrial and consumer goods.
Another question mark is the credit markets. At the index level, credit spreads look benign, but the spreads of the lowest quality, weakest credits remain stubbornly high, indicating that credit risk may be higher than expected. The lasting underperformance of US small caps relative to large cap reflects this as well. As long as this remains the case, there will continue to be isolated downgrades and bankruptcies, but it looks far from a widespread credit event thanks to companies having been able to refinance their debt as corporate cash flows have remained positive. Of course, the potential for additional downgrades, as was seen with Ford, remains high due to BBBs being 50% of the investment grade debt market.
High Yield Spreads Remain Wide
The heightened uncertainty on the path of interest rates provides traders with ample opportunities as evidenced by the recent rise in the index that measures volatility in the Treasury markets.
Volatility Rises for Treasurys
Cuts. How Deep?
So what, are the largest opportunities out there for hawkish or dovish positioning?
A moderately hawkish outcome is more likely what traders could see. The markets are pricing in additional cuts in 2019 – likely as soon as October. This cut would be consistent with the mid-cycle adjustment of 1998. Any more than that would risk a loss of credibility by the Fed and potentially spook the markets, which is why even if the cut comes this month, policy makers will likely continue to emphasize underlying economic strength even if uncertainties are growing. This could likely see a repeat of September which would cause the yield curve to flatten as the long bond comes down.
On the other hand, the FOMC could surprise with a 50 bps cut along with the reintroduction of quantitative easing, even if they do not call their T-Bill buying program that. This would likely be what finally sees the US Dollar weakened against major currencies; although, monetary policy in Europe and Japan will remain easier than the Fed, so the move may not last, making this more of a trade than an investment. We would also see short-term yields collapse and the yield curve steepened sharply.
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