There was a bit of “what does the Fed know that we don’t” after the extremely dovish posture taken at Wednesday’s meeting. Well, we may have gotten part of “what they know” this morning after some truly wretched manufacturing numbers out of Germany and France that were clearly in contractionary, if not recessionary, territory. That has Treasuries rallying and the curve flattening to yearly lows. The 10-year yield pushed as low as 2.46% and is currently holding at 2.47%. That’s the lowest yield since January 2018. Meanwhile, the 2yr-10yr curve has flattened to 10.78bps, within arms reach of the 10.69bps cycle low from last December. Oh, and the 2-year note has rallied to 2.36% and is the first time it’s pushed below the effective fed funds rate in this tightening cycle. You think the market is signaling we need an ease? It is. With the yield curve inverted out to five years (5-yr yield 2.28%) the question is fast becoming not when the Fed will hike again, rather, it could be why aren’t they in cutting mode already? In defense of the Fed, if consumer spending rebounds in the second quarter (and they have the firepower do that), and the global slowdown stabilizes, and the geo-political issues recede a bit, a steady-as-she-goes approach may be appropriate. But make no mistake if those items don’t get resolved positively, or get worse as they seem to be doing, we could very well be staring at a possible rate cut at the June meeting.
Remember in December when the FOMC met, hiked rates another 25bps for the fourth time in 2018, and were practically ebullient about the state of the economy? That does seem like a long time ago doesn't it? Fast forward to Wednesday’s FOMC meeting and the Fed has adopted another tone towards the economy and it’s most definitely dovish. While the market was expecting a no hike posture from the Fed and softer rate and economic forecasts, Fed officials did the market one better and did every dovish thing except cut rates.
While Chair Powell repeatedly characterized the domestic economy as solid in his press conference, the downshift in economic and rate expectations, and the abrupt end to balance sheet tapering by September left markets with a somewhat stunned look. While equities initially rallied on the cut in planned rate hikes in 2019 from the two in December’s forecast to none in Wednesday’s outlook, they eventually turned lower again as the thought that “what do they know that we don’t” crept into the market psyche and stocks turned lower.
While numbers from Europe indicate the slowdown there is deepening, the Fed’s posture may not be so much a “what do they know that we don’t” as it is a realization that sitting at 2.25%-2.50% in fed funds and looking across the global landscape and at that low level they don’t exactly have a lot of firepower to combat a serious economic downturn. Thus, there is an asymmetry of risk in that a slowdown will be awfully hard to combat only 250bps from the zero lower bound. Why aggravate such a situation with forward guidance of rate hikes? And while a downshift in expected 2019 growth to 2.1% is not, in and of itself, something to panic over, when looking across the global landscape potential headwinds have only strengthened since December and that does represent a real risk.
At this point what does this mean for rates? Well, the yield curve is already signaling the Fed should be in cutting mode with the curve inverted out to five years (5-yr yield 2.28%), and the 2yr-10yr spread flattening to 10.78bps and the even more definitive Fed-easing indicator, 3mo-10yr spread, at 0bps! While yields are creeping into inversion further along the curve, the Fed probably won’t sit idly by and watch the influential 2yr-10yr and 3mo-10yr invert and stay there. To combat that would entail a rate cut which would no doubt induce a strong rally on the short-end as a single rate cut (and it could just as easily be 50bps as 25bps) would most likely be followed by another.
On the long-end consider too what the Fed has wrought from Wednesday’s proceedings. They not only fixed a September date for ending balance sheet tapering, which is a shorter time than most expected, they also announced a cut in the cap on maturing Treasuries not to be reinvested from $30 billion/month to $15 billion beginning in May. In addition, beginning in October the Fed will reinvest up to $20 billion/month in returning MBS principal into Treasuries. Amounts over $20 billion will be reinvested into new TBA MBS.
Thus, the Fed will be a much bigger investor this year than anyone would have expected earlier this week. Some estimates have additional purchases this year coming as a result of the quicker end to tapering and the other reinvestment changes in the $180 billion area. Primary dealers estimate a net increase of $79 billion in Treasury coupon issuance for the second half of 2019 versus 2018. Thus, the Fed will be scooping up far more Treasuries than the increased issuance due to the wider budget deficit. That will benefit long-end prices as the Fed’s reinvestments will occur at the bi-monthly Treasury auctions with allocations weighted pro-rata by the amount of maturities being auctioned.
3mo–10yr Spread & Fed Easing
While investors have no doubt been watching the 2yr-10yr Treasury spread narrow, the Fed is likely looking at another indicator: the 3mo—10yr spread, which is an even better tell on when the Fed may shift to rate cuts. As the graph shows, in the last two easing cycles the 3mo –10yr spread inverted just prior to the first easing, which also occurred just before the onset of recession. Following Wednesday’s Fed meeting the 3mo –10yr spread dropped to a low of 7.6bps and is flirting with inversion this morning, sitting at a 0bp spread. If the 10-year continues to rally it will be a big sign that a rate cut is coming soon.