The Federal Reserve was already behind the market, prior to Wednesday’s meeting. The “dot plots,” the Fed Governor forecasts for future Fed Funds rate increases, are now closer to the market’s thinking. For now, the hiking cycle is done, with zero increases expected in 2019 and a median forecast for one hike in 2020.
What was more dovish than expected, and possibly more responsible for the 10bps decline in 10-year bond yields post-meeting, was the change in balance-sheet reduction. The run-off of Treasury and mortgage securities held by the Fed will slow its pace, starting in May. This is a total 180 from what Fed Chair Jerome Powell said in 2018, when he remarked that the balance sheet run-off was on “auto-pilot.”
Overall, the dovishness extended beyond the normal commentary on the short end of the yield curve. Accompanying the balance sheet and rate outlooks were growth rate forecasts for 2019 and 2020, which ratcheted down slightly. The median expectation for US economic growth in 2019 and 2020 is now 2.1% and 1.9%, respectively. That’s down from the previous forecasts of 2.3% and 2.0%.
Recall that the Fed is “data driven.” It now appears to be market driven as well. The “Powell Put” is firmly in place and he has now backtracked from previous comments on both the neutral rate and balance-sheet reductions, which is probably the single largest contributor to the market’s 180 since Christmas Eve. The monetary environment from global central banks can only be characterized as accommodative, with real interest rates back to just about zero, again.
Channelling the much-overused Gretzkyism, “skate to where the puck is going, not where it is right now,” our view has been and remains that the economy is slowing but a near-term recession is unlikely. We had been early in taking off our bond-market hedges, with the 10-year yield now at January 2018 levels, which hasn’t cost us much because risk assets have performed well so far in 2019. We don’t think it’s the time to re-hedge with long bonds and we are not calling for a return of the 2016 fixed-income environment.
Going the other way, there are some market trends that are worth watching closely today, with respect to inflation and growth. The implied inflation rate in TIPs (the difference between 10-year yields and inflation-protected bond yields) has already bottomed. It’s happened not just in the US, which is nearing 2% again, but also in Europe.
The most recent headline CPI number in the US is 1.5%, but core inflation (which removes food and energy) is 2.1% year-over-year, in line with the Fed’s target levels. Wage inflation is over 3% year-over-year and at cycle highs. Oil has quietly rallied back to almost US$60 per barrel, which means it will likely be a higher year-over-year number in the second half of the year, putting upward pressure on headline inflation. Copper prices have been firm and are halfway back to highs from a year ago. It doesn’t appear that US or global growth is in a downward growth spiral; if anything, there appear to be “green shoots.”
In summary, with quantitative tightening proceeding at a slower-than-expected pace starting in May 2019, it makes sense bond yields reacted to the announcement by going lower. The change is minor though, compared with the fact that US budget deficits are still $1-trillion (which must be financed) and the European Central Bank is no longer conducting quantitative easing. The bond bear market doesn’t go in a straight line, but for investors with a time horizon, it still makes sense to assume there’s a headwind in bond yields. Today, around 20% of the world’s government debt is back to negative yield. This isn’t a normal state.
— Sandy Liang, CFA, is the Head of Fixed Income at Purpose Investments. He is the lead portfolio manager for a number of funds, including Purpose Strategic Yield Fund, Purpose Canadian Preferred Share Fund and Purpose Credit Opportunities Fund.
All data sourced from Bloomberg unless otherwise noted.
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