We mentioned in our Monday morning article that with the week relatively light on economic data the evolving nature of the trade war would dictate market levels and that certainly has been the case. The latest salvo was a trio of Asian central banks easing rates overnight with New Zealand cutting 50bps, India 35bps, and Thailand 25bps. There’s probably more to come as these countries are suffering collateral damage in the US/China trade war and trying to soften the blow to their weakening economies. Those cuts have sent a shudder through our markets with Treasury yields falling further and equities looking to suffer another bout of selling today. When China allowed its currency to weaken above seven yuan to a dollar on Monday it signaled a loss of patience with the U.S. and also signals any near-term trade deal is off the table. With rates moving lower in light of the latest developments we explore what this means for the fed funds rate, longer-term yields and for the economy in general. Read on to see.
Investors are trying to digest the latest tit-for-tat with China but what is clear is that any hope that may have been harbored for a somewhat quick resolution is a fading memory. Both sides are digging in with domestic politics driving the decisions from this point rather than matters economic. That has the fed funds futures market rapidly adjusting its outlook and it points to lower rates all along the curve.
First, fed fund futures are pricing in not only two more hikes this year, they are also pricing in a 40% chance that things deteriorate so rapidly that a 50bps cut will be necessary in September. The other 60% are still siding with a less panicky 25bps cut. Looking ahead to 2020, futures have adjusted downward to the latest ramping up of trade rhetoric. Futures for the end of December 2020 predict a funds rate at 1.00%, representing a total of six 25bps cuts in the easing cycle.
The question investors are grappling with today is of those six forecasted cuts through 2020 should the Fed consider a fourth cut by December this year? Assuming they follow the July cut with another in September and October, that leaves the December meeting with the potential for yet another move. If the trade war continues like it has this week, a December cut is certainly a possibility but there is plenty of time between now and then. The president knows where his bread is buttered vis-a-vis the stock market and if the risk-off selling in equities persists, we expect some face-saving move may become a reality.
For its part the Fed seems a little behind the curve to the latest developments with St. Louis Fed President James Bullard saying that the Fed has already “done a lot” and that the Fed can’t react “tit-for-tat” to each development in the trade war. Bullard said he wants to see the effect of the July rate cut before determining the next move. Given most rate moves take fully six months to work through the economy that may be a luxury the Fed can ill afford in the current climate. That hesitant voice by Bullard, who is probably the most dovish of the voting FOMC members, is possibly contributing to early weakness in equities today. Such is the skittish state of markets right now and that level of concern/uncertainty needs to be incorporated into the Fed’s calculus.
Looking further along the Treasury curve, 2-year yields at 1.54% appear fully priced for another two rate cuts in the coming months, while the 5-year yield at 1.44% actually looks a bit cheap if the more aggressive rate-cutting prospects become a reality. The 10-year yield at 1.63% has a lot of pessimism built into it such that any reprieve on trade will allow a reflexive equity rally and a back-up in yields. If that happens, however, it seems unlikely that yields will push above 2% as we would assume buy programs kicking in at that psychologically important level, especially with nearly $14 trillion in negative yielding debt in investors hands across the globe. If things continue to deteriorate—and that weak July ISM Non-Manufacturing number yesterday could be a canary-in-the-coal mine moment—10-year yields will eventually challenge the all-time low of 1.36% set back in July 2016.
One issue that could mark something of a low in yields for the time being is an issue we’ve been waiting to hear voiced and it was after Monday’s rally. That is the so-called convexity-hedging trade. As mortgage investors watch yields drop, the risk of increased prepayments rises and shortened durations become a real possibility. In order to offset this shortening of duration these investors will buy 10-yr and 30-yr Treasuries. Those purchases obviously drive yields even lower. Typically, in past rallies once the convexity-hedging trade is trotted out as an explanation for low yields it represents a market top. Of course, it’s hard to say when that trade has run its course, and today’s rally on the long-end probably has its share of convexity hedgers in the market, but it does seem if we get a reprieve on the trade front that a back-up is possible. Any back-up, however, is likely to be short and limited in magnitude. Yields are ultimately headed lower, across the curve, but that won’t happen in a straight line so take any back-ups as a chance to put funds to work.
Chinese Currency Weakens But Well-Off Historical Levels
With the U.S. declaring China to be a currency manipulator it raises the stakes in the trade war, but is the designation warranted? The graph shows the number of yuan per dollar so as it rises it indicates a weakening in the currency as it takes more yuan to purchase a dollar. As shown, the early years were characterized by China actively managing the exchange rate to a fixed peg. Prior to the recession, China began allowing the yuan to float and it gained through 2013. Since then it has generally been weakening and you can see the most recent bout of abrupt weakness. While the latest weakness is no doubt attributable to government action, the graph also shows there could be plenty more weakening if the Chinese so desire.
Agency Indications — FNMA / FHLMC Callable Rates
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