Welcome to 2019! If you were hoping the market had left its volatility and angst behind in 2018 don’t count on it. The drivers of much of the volatility: trade war drama, White House drama, and slowing global growth are only likely to increase this year. For example, we have the ongoing government shutdown and we also have a new Congress convening tomorrow with Democrats set to take the House. They will move quickly to pass a bill reopening the government and send it over to the Republican-controlled Senate. Where it goes from there will be the first bit of political intrigue in 2019, with plenty to follow. Yields finished the year in a downtrend, driven by a combination of concern over slowing growth, increasing political gridlock and collapsing oil prices. We see those forces continuing into early 2019 with yields likely to continue probing to the downside with only limited back-ups. Let’s call it a 2.50% - 3.00% range for the 10-year in 2019. Meanwhile, the market is pricing for the Fed to pause for all of 2019 as the 2-year note has dipped to 2.49%, matching the upper end of the current fed funds rate. We tend to agree with the pausing expectation, at least for the first half of the year (more on that below).
|Economic News||Oil Prices Guiding Yields Lower||Agency Indications|
The Fed has come in for its share of blame for some of the recent equity bloodletting as it was perceived they were not as sensitive to the market selling and concerns. One bit of good news is that every Fed meeting this year will have a press conference for the Chairman to address in more detail the Fed’s thinking and policy actions. That also makes each meeting live but we believe any rate hike this year will be mid-to-late year development.
While the Fed doesn’t want to appear cowed by presidential tweets, or even face-to-face presidential meetings, by hiking into the lower range of neutral last month they would be justified in pausing to see how the nine hikes to-date and balance sheet reductions are working through the economy. With GDP expected to slow from 3% in 2018 to the mid-2% level, and inflation expectations trending lower as well, the Fed has economic justification to pause as well. While the market was disappointed in the lack of a more dramatic cut in expected rate hikes for this year, cutting from three to two was perhaps just the opening act with further revisions possible in March.
Speaking directly about inflation, the Fed pays a lot of attention to inflation expectations so when those expectations are not “well-anchored” or, in fact, are decreasing it will make members nervous and likely to pause until inflation and inflation expectations start to turn higher. One way to get those numbers higher is for oil to stop collapsing. That, as much as anything, is feeding lower yields and as long as oil fails to find a bottom inflation and inflation expectations are likely to follow along accordingly.
The market, meanwhile, is not waiting for a more dovish Fed to appear, they are already presuming a dovish Fed is a foregone conclusion. Odds of a rate hike in March have fallen under 5% and, in fact, the highest odds of rate hike this year are 9% for the June meeting. The 2-year note yield has fallen just under 2.50%, same as the fed funds rate, and that is another indication the market thinks the Fed will be in pause mode for all of 2019.
So a fed funds rate stuck at 2.50% for much of the year likely leaves longer rates in range bound mode as well with the 10-year oscillating between a flat curve at 2.50% to 3.00%, if growth and inflation accelerate. We don’t expect either of those, however, to happen. With increasing global uncertainty stemming from Brexit, to trade wars, to a soon-to-be expiring debt ceiling, not to mention increasing political friction with the new Democratic House majority, global and domestic uncertainty is only likely to worsen. That seems to warrant longer-end rallies towards 2.50% with only grudging back-ups that aren’t likely to challenge 3.00% any time soon.
While the Fed says they are data dependent the data are already pointing to some slowing as the softness in housing and autos bleeds into other sectors. Consumer confidence too is likely to take a hit as people see the damage to their 401(k) and other retirement plan savings. Consumers will also be calculating their tax returns and for many tax cuts may not be as kind to their pockets as the political rhetoric implied. That adds up to a challenging environment, at least early in 2019.
Finally, the December jobs report is due Friday and it’s expected to show a rebound in job growth to 185,000 from 165,000 in November but no change in the unemployment rate (3.7%), while average hourly earnings stay around the 3.0%YoY level. A Fed that had stable to increasing inflation expectations could justify continued hiking with that type of jobs report. But as we mentioned, with oil collapsing and inflation expectations trending south, it will likely take a series of stronger-than-expected jobs reports to keep the Fed in tightening mode, and given we are long-in-the-tooth in this economic cycle, and with business jitters increasing from the market bloodbath, that may be hard to accomplish.
Oil Prices Guiding Yields Lower
Divining the sources of lower yields is a tricky proposition what with concerns over slowing global economies, increasing trade war rhetoric and political gridlock. But one need only to look at the price of oil and 10-year Treasury yields to get a glimpse of one of the main drivers of lower yields. Oil prices are dropping from a combination of softening demand and increasing supplies. We could have also added inflation expectations to the graph which have been declining as well, but that is a consequence of oil’s plunge and the perception of slowing global economies. In any event, as long as oil remains under pressure it’s likely to keep yields and inflation expectations down as well.
Agency Indications — FNMA / FHLMC Callable Rates