With financial markets closed today in observance of the Day of Mourning for former President George H. W. Bush investors have the opportunity to pause and reflect on the significant curve flattening that has occurred this week as well as the volatility in stocks. The 3yr-5yr curve inverted Monday and that was followed by the 2yr-5yr inverting yesterday. The more widely watched, and important, 2yr-10yr spread moved to cycle lows of 11bps yesterday with 9bps of curve flattening occurring during the week. This week’s curve flattening has occurred during both the risk-on rally on Monday and the repeal of that rally yesterday. Inflation expectations are dropping, and with a Fed intent on getting another hike on the books later this month investors are perhaps interpreting that the Fed is close to making a policy error if they don’t soon relent from their hiking quest. We discuss this in more detail below.
|Economic News||LEI Still Points to Healthy Economy Despite Curve Inversion||Agency Indications|
The equity flogging yesterday has it’s roots in two causes and both we find a little suspect to warrant the kind of selling we experienced. The initial burst of selling came off some confusion over what was exactly agreed to in Buenos Aires between President Trump and Chinese President Xi on trade. The 90-day suspension of increased tariffs in exchange for additional agricultural purchases by the Chinese seemed to be beyond dispute. The president’s tweet, however, that the Chinese were also repealing tariffs on U.S. cars was not confirmed and then the whole matter was suddenly thrown into some confusion.
The question we have is why the tentative framework of a deal was treated so enthusiastically on Monday? If there’s one thing we’ve learned from the Trump administration is that they tend to oversell the benefits of pending negotiations/deals, but when the rubber meets the road the reality is usually something less than the promotion. In any event, the rally on Monday in the afterglow of a trade truce gave way to the reality that the heavy-lifting for a deal still remains.
The equity sell-off then got additional fuel from further curve inversions as the early equity selling led to further curve flattening with the 2yr-5yr curve inverting and the 2yr-10yr spread reaching a cycle-low of 11bps. That flattening crushed the financial sector due to the income-limiting nature of a flattening curve not to mention the credit risk component stemming from the recessionary signal that curve inversions imply.
What we find amusing, however, is the quick and vicious selling in financials. The yield curve has been flattening for more than a year and while the most recent flattening move has been impressive we’re hard-pressed to find reasons to go with the most recent equity selling. First, curve inversions may signal recessionary conditions but they also can take years to come to fruition. That certainly seems the case here with most economic indicators—save the interest-sensitive housing and autos— still pointing to solid economic performance. Secondly, the Fed, in the form of Chairman Powell, last week unveiled its financial stability framework and asset valuations and volatility were a big part of the framework. Powell mentioned that “large, sustained declines in equity prices can put downward pressure on spending and confidence.” Thus, the Fed has signaled they are watching stocks and may very well pause to avoid the “large, and sustained price declines.”
In fact, the speeches last week from Chair Powell and Vice Chair Clarida convinced us that the Fed has moved from the methodical quarterly cadence of rate hikes to a more pragmatic data-dependent decision process. While a December hike is nearly a foregone conclusion, a pause as early as March is possible if the data begins to slow and equity volatility continues.
Also, the Fed is mindful that there are a host of geo-political risks that could further undermine global growth and eventually impact the U.S. economy. Infighting in the U.K. over Brexit is increasing with the March deadline approaching, and the E.U. is also confronting a populist government in Italy that is threatening many of the norms of that institution. And if the China trade negotiations get bogged down expect Trump to pivot to the E.U. and the auto tariffs on imported German cars. That’s a road filled with potholes that can undermine even a strong economy not to mention one that is confronting a flat yield curve and an uncertain trading environment.
While the Fed looks at the strong labor market it undoubtedly would like to engineer a few more hikes in 2019 but if inflationary trends continue to wane, like they have been, the impetus to effect those hikes becomes a little less intense. Thus, while the yield curve is signaling that the Fed is venturing close to policy error if they continue with quarterly hikes into 2019, we think the softening in inflation readings and gathering geopolitical clouds gives them a solid rationale to pause. After December they will have booked ten rate hikes with quantitative tightening ongoing for more than a year. Thus, a lot of tightening will have already taken place, and as we approach the lower edge of neutral with inflation looking to soften we think the Fed may start to see a March pause as something that deserves a bit more consideration.
LEI Still Points to Healthy Economy Despite Curve Inversion
The beginnings of yield curve inversion and the potential recessionary implications it portends jolted equity investors awake and the selling was hot and heavy. What needs to be mentioned is that yield curve inversions might signal a risk of recession but the time to onset is usually measured in years not months. Another useful recession indicator is the Leading Economic Indicator. The graph tracks the LEI over the last 50 years and as you can see in all cases the LEI trends down, passing into negative territory, before the onset of a recession. Currently, the index is a healthy 5.9 and has been trending higher. So, inverted curve or not, the LEI is still signaling a healthy economy.
Agency Indications — FNMA / FHLMC Callable Rates