Bonds: Total Market
US core retail prices came in soft in new data this week. The US core consumer price index, which excludes food and energy, rose 0.1% from the previous month and 2% from a year earlier in March. The readings both underperformed expectations, but are not considered indicative of a recession or any real economic trouble.
FINSUM: This data reinforces the idea that we are in a goldilocks moment with the economy. Let’s see if that continues. If it does, it sets up a nice environment for asset price growth.
For the last year all the fear in bond markets was about inflation and how the Fed would handle it. Were we going to be hiked into a recession? Now all of that has shifted and fixed income gurus are concerned over an entirely different beast—recession. In many ways the fears of recession have become so strong that they are intimidating the market as a whole, making the term “bond vigilante” more than appropriate here.
FINSUM: The speed with which the bond market has reversed since December is pretty alarming. We do wonder if this inversion might be a false signal.
The professor who first identified yield curve inversions has written an article explaining what the development really means. First identified in 1986, a yield curve inversion is considered the most widely accurate indicator of recession. Since it was first identified and back tested, it has accurately predicted a further 3 out of 3 recessions. This is a point its “discoverer” Campbell Harvey hammers home in his article. He explains that an inversion is usually followed by a recession within 12-18 months. The yield curve has not been inverted since before the Crisis, but just did so on Friday.
FINSUM: One of the important points Harvey makes is that in order for the inversion to really indicate a recession, it needs to remain in place for at least three months. We are only at one day.
It finally happened. After dangling on the edge of an inversion for months, the US yield curve has just officially crossed into one. The gap between 3-month and 10-year Treasury yields is now negative. 10-year yields have been falling, recently hitting a low of 2.439%. Yield curve inversions are seen as the most reliable indicator of forthcoming recessions. Yields have been falling as a reaction to a highly dovish Fed and weakening economic data.
FINSUM: This is a reason to worry about he economy, but remember that there is often a long lag between an inversion and a peak in the stock market.
The whole market rally this year has pretty much been predicated on the Fed u-turning on rates. This makes sense, as it signaled that the Fed was not going to hike the economy into a recession. However, there are reasons to be nervous that the Fed may reverse course. One top economist thinks that the Fed may hike twice more this year as strong economic data will start to push Powell’s hand. US service industry data has been quite strong, and overall, “The fundamentals are not that bad. That could mean Powell has no choice but to hike.
FINSUM: We don’t necessarily agree with this view. While we are nervous about the Fed reversing course, we don’t think they will be under pressure to do so until inflation actually heats up.
Once you admit that this 2019 rally is almost purely predicated on the Fed dramatically turning around its position on rates and the economy late last year, you come to a realization: it could all end so quickly. The market is very vulnerable to the Fed’s actions right now, so the question becomes—will the central bank turn hawkish? The short answer is that it doesn’t look like the Fed will get hawkish any time soon. New language released in the latest notes look even more dovish than in December. The key buzzword is that the Fed is looking to be “patient” on rates and says it would need clear upward signs in the economy to hike any further.
FINSUM: The Fed has set up another goldilocks situation for markets. So long as data is okay but not too good, asset prices will be fine. If some data comes out poorly, the market knows the Fed can cut rates. Are we in for another big bull run?