The FOMC meets Wednesday and is widely expected to hike rates 25 bp. Markets will be more interested in what the Fed sees for 2019 and 2020. In that regard, it is quite possible that the Dot Plots tilt slightly more dovish, but we do not think the FOMC statement will veer much from recent Fed communication.
The 10-year yield broke decisively below 3% on December 3 and has remained there ever since. At 2.87% today, it is still very low but is up modestly from the 2.82% low. Odder still, the 2- to 5-year portion of the US yield curve recently inverted for the first time in over a decade. This has shifted a bit in recent days and it is now the 2- to 3-year portion that is slightly inverted.
An inverted US yield curve has been the market bogey-man this year. While falling short of the more widely-followed inversions (3-month to 10-year, 1- to 10-year, 2- to 10-year), we think that this current inversion of a small portion of the curve is still spooking investors as global equity markets remain under pressure. Curve inversion has been shown to be an extremely reliable indicator of recession,
There’s no doubt that the US yield curve has flattened significantly over the past several years. The 2- to 10-year spread is currently the lowest of the three spreads at around 15 bp, up from 13 bp two weeks ago but still nearing inversion. The 3-month to 10-year spread, which the San Francisco Fed has shown to be a better predictor, is by comparison a whopping 46 bp. This spread is at cycle lows but still far from inverting. To us, the minor 2-, 3-, and 5-year inversions still seem to be more of a quirk from the flat yield curve than a precursor of something more ominous.
Market expectations for the December 19 FOMC meeting have been largely unaffected, with WIRP showing nearly 75% odds of a hike this Wednesday. The adjustment has been seen further out as the implied yield on the January 2020 Fed Funds futures contract is currently around 2.58%, near the 2.56% low from last Monday. That was the lowest since May 31 and down sharply from a peak near 2.95% on November 8. With effective Fed Funds trading around 2.19%, this current implied yield shows less than one hike is priced in for 2019 after the widely expected hike this week. The market is also starting to price in rate cuts in 2020.
Markets will be very interested in the December Dot Plots. Looking at the dot clusters from September, it would be easy to envisage a shift down from the three hikes currently signaled for 2019. For instance, if two members move their end-2019 rate from 3.125% to 2.875%, the median would likewise drop 25 bp to 2.875%. Nor would it be hard to see a shift down the longer-term neutral rate, which is currently at 3%. For instance, if only one member moves from 3% to 2.75%, the median would drop 25 bp to 2.75%.
Michelle Bowman was recently confirmed as Governor, and so her contribution to the Dot Plots will be new and unpredictable. She brings the total number of contributors up to 17. Governor nominees Goodfriend and Liang still need to be confirmed by the Senate before all 19 contributors are fully represented in the Dot Plots.
While there may be a dovish shift in the Dot Plots, we do not think the Fed statement will veer much more dovish. Previous comments from Clarida and Powell have already done the heavy lifting with regards to messaging, and we do not think the Fed wants to become characterized as becoming even more dovish. There may be a slight tweak in the language that suggests more data dependency in 2019, however.
The makeup of the FOMC changes every year. Currently, the FOMC is made up of the 5 members of the Board of Governors (Powell, Clarida, Quarles, Brainard, Bowman), the 5 voting regional Fed Presidents (Williams, Barkin, Bostic, Daly, and Mester), the 4 alternates (Bullard, Evans, George, and Rosengren), and the 3 non-voters (Harker, Kaplan, and Kashkari)). The Board of Governors and the NY Fed are always voting members. In 2019, the rotation will see the 2018 alternates (Bullard, Evans, George, and Rosengren) become voting members.
The bond market rally and heightened recession fears come despite firm US data in November. Last month, 155k jobs were created and October was revised down to +237k from +250k initially. While the headline number was disappointing, average hourly earnings rose 3.1% y/y and remain at that cycle high. Retail sales jumped last month, as did IP. ISM manufacturing PMI jumped to 59.3 from 57.7 in October and is just below the cycle high of 61.3 from August.
The US economy remains relatively strong in Q4. Stronger than expected November retail sales and IP data boosted the Atlanta Fed’s GDPNow Q4 growth forecast to 3.0% SAAR from 2.4% previously. Surprisingly, the New York Fed’s Nowcast was steady at 2.4% SAAR despite the strong data Friday. Sequentially speaking, growth has slowed from the 4.2% SAAR peak in Q2 to 3.5% in Q3 and near 3% so far in Q4. However, growth remains above trend, widely recognized to be around 2%. Note that Bloomberg consensus shows US GDP growth remaining above 2% on a SAAR basis until Q1 2020 and above 2% on a y/y basis past Q2 2020.
Yet markets seem to be focusing on the recent easing of some inflation measures. Core PCE, the Fed’s preferred measure, fell to 1.8% y/y in October after spending several months at the Fed’s 2% target. However, it is expected to tick back up to 1.9% in November when data is released Friday. The US 5-year TIPS breakeven rate is currently around 1.59%, the lowest since June 2017. This strikes us as quite low given headline CPI inflation of 2.2% y/y in November.
With the labor market so tight and likely to get tighter, we still firmly believe that wage pressures will move higher. We think that reports of the death of the Phillips Curve have been greatly exaggerated (more on this in a future MarketView piece). This in turn would filter through to generalized price pressures.
A weak spot for the US is developing on the fiscal side. The November budget deficit widened to -$199 bln, bringing the 12-month total up to -$876.7 bln. This is just below the cycle high of -$890 bln posted in August. Expenditures have jumped while revenues have contracted y/y in 8 of the 11 months so far in calendar year 2018. The FY2018 (through September) deficit was -$779 bln (-3.8% of GDP), the largest since FY2012.
The Congressional Budget Office (CBO) forecasts the deficit to widen to -4.6% of GDP in both FY2019 and FY2020. It is seen widening further to -4.9% of GDP in FY2021. These forecasts worsen despite no recession being assumed by the CBO. Indeed, the CBO forecasts GDP growth of 2.9% in 2019, 2.0% in 2020, and 1.5% in 2021. When (not if) a US recession occurs, it will likely be a fiscal nightmare. Past US experiences suggest the deficit could blow out to -6% of GDP in FY2020 and even -8% of GDP in FY2021 if there is a prolonged recession.
We downplay the significance of the recent shift in Fed messaging as well as rising recession fears. Recent US economic data suggest markets are still underestimating the Fed’s capacity to tighten. While much depends on the US economic performance in 2019, we think US rates are likely to rise more than what markets are expecting. This is dollar-positive and equity-negative, to state the obvious.
Recall that while markets are intently focused on the 10-year yield, the Fed only sets short-term money market rates. With price pressures expected to move higher, we are not as concerned about the prospects of an inverted yield curve as many others are. Instead, we look for an eventual parallel shift upwards in the yield curve as the Fed continues to hike, with risks tilted towards a bearish steepening if price pressures intensify as we expect.
Of course, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows or goes into recession, then the Fed will have no choice but to adjust its expected rate path. But for now, the economy can cope with and needs more tightening. Our best guess for a US recession is early 2020, but clearly this is open to revision as we move through 2019.
While being dollar-positive, a steeper US rate path than what markets are currently pricing in will be very, very negative for EM. This is especially true for the debtor/deficit countries like South Africa, Turkey, Brazil, India, and many more. On the flip side, the surplus/credit countries like Korea, Singapore, and Taiwan are likely to hold up relatively better.
It’s worth noting that while US recession fears have risen, the bond market is so far ignoring the potential negative impact on US Treasuries. Our nightmare scenario would see an explosion in UST issuance even as the Fed is likely to be cutting rates in response to the recession. We believe this scenario would be the game-changer for the dollar. Rather than the current dollar-supportive mix of tight monetary and loose fiscal policy, it would quickly turn into a dollar-negative mix of loose monetary and tight fiscal policy. To be continued…….