The bond market seems to have blind faith in the Fed right now. Longer-term bond yields have fallen dramatically, a sign that fixed income investors are sure the Fed is not planning any moves. Not only are bonds up considerably lately, but implied volatility is very low. That means investors are discounting both the chance for an inflation increase and an economic downturn. In other words, they think the economy and Fed is going to stay right where it is.
FINSUM: Can you blame them? The economy lingered in what we think of as an investor’s “goldilocks” phase for several years after the Crisis—inflation not too low, not too high, Fed on hold, asset prices rising. It does not seem unlikely we go back into that mode.
Bonds and stocks are sending different signals right now, and it is hard to tell which side is correct. Bonds are reflecting an increasingly bearish outlook on the economy, with yields falling. Stocks, on the other hand, have been jubilant so far this year. The reality is that both sides cannot be correct. Historically speaking, bonds have usually been more astute is measuring the direction of the economy and markets, and if that is the case, then we would be headed for a downturn.
FINSUM: The Fed really weighed in with its view yesterday and they are clearly worried about the direction of the economy. Are bond investors right again?
Bloomberg has put out a very bearish article on the economy. The publication is arguing that there is a 2/3 chance of a recession beginning this year, and that a bear market is likely to happen alongside it. As evidence of the pending downturn, the article cites these as indicators: the nearly inverted yield curve, the big fall in stocks in Q4, weak housing activity, terrible February payrolls, and the fact that the rest of the world is slowing. One of the most acute worries though is that the Fed will keep hiking as part of an effort to leave itself room to cut rates in the next recession, an action which could drive the economy into a recession.
FINSUM: Again, much of the direction of assets and the economy depends on the Fed’s mindset. If the central bank returns to hiking, a recession looks like a sure thing. But if not, it is far from certain.
There are a lot of good reasons to own Treasuries right now, and a lot of reason to be nervous about them. Let’s take a look. The biggest risks in the market at present are mostly about the budget deficit, which makes Treasuries look weak and inflation likely to jump (as it has historically during such spending). However, there are a lot of positives too. The big one is that the Fed looks ever more likely to adopt a permanently dovish stance as it may be changing its thinking about inflation. Additionally, economic weakness will be bullish for Treasuries, so coming to the end of the cycle is not catastrophic.
FINSUM: The best place to be on the yield curve is clearly at the short end—less rate risk and decent yields.
The market seems to have forgotten about 2013’s Taper Tantrum. The bond markets appear to feel like they are back in the driver’s seat, and seemingly no one expects the Fed to suddenly turn hawkish. A similar set up existed in 2013 prior to the big market meltdown referred to as the “Taper Tantrum”. The thing to bear in mind is that Fed chief Powell has made clear he doesn’t like being bossed around by the White House or the markets, so will not be afraid to be one step ahead of markets in making a sudden hawkish move. It is important to remember then that a survey of economists shows that they expect another rate hike this year.
FINSUM: The Fed is made up of economists, so that survey could have value. That said, we do lean towards the “no further hikes” in 2019 camp.