From hawk to dove?
While the Fed’s approach to raising rates created concern in 2018, it may be shifting its stance. In December, the Fed appeared to adopt a more dovish view as higher market volatility contributed to tighter financial conditions. Chairman Jerome Powell announced rates were close to neutral, neither stimulating nor slowing the economy.
At its December meeting, the Fed projected two increases in 2019 (down from the four it made in 2018). Market participants now think the Fed may not raise rates at all in 2019, and markets are currently pricing no expected rate hikes this year.
The Fed has two mandates: keep employment high and inflation low. For now, it’s winning on both fronts. The question is whether the Fed’s focus on keeping inflation low risks pushing the U.S. economy into a recession. Uncertainty about the economy’s direction means the Fed will depend heavily on economic data in future decisions.
The 10-year Treasury rallied from its high in early November back to levels last seen in early February 2018
Yield curve flashes yellow
The interest rate yield curve also reflects rising concern over future economic growth, with the gap between long- and short-term interest rates flattening.
Many analysts view an inverted yield curve, in which long-term rates fall below short-term rates, as a predictor of a future recession — and in the fourth quarter, the curve between one- and seven-year Treasuries inverted. The Fed’s research shows an inversion of the three-month and 10-year Treasuries has been the best recession predictor, and right now the 10-year yield remains higher than the three-month. Inverted curves are imprecise in predicting when a recession may take place, occurring as much as one to two years before a downturn.
Credit markets had a very tough quarter. As gauged by the Bloomberg Barclays U.S. Corporate High Yield Index, high yield bonds produced a negative total return of over 4.5 percent during the quarter, finishing the year down 2 percent; additionally looking at the Bloomberg Barclays U.S. Corporate Bond Index investment grade bonds produced a negative excess return of over 3 percent for both the fourth quarter and the year. Treasuries became a safe haven in the fourth quarter, as the Bloomberg Barclays U.S. Treasury Index returned over 2.5 percent. Investors are nervous enough to make quality their to priority.
Inflation expectations have plunged, with the TIPS (Treasury Inflation-Protected Securities) rate falling to 1.76 percent (as of January 4, 2019), well below the Fed’s 2 percent inflation target rate.
U.S. Treasury Yield Curve