Fixed Income Outlook  |  Q3 2019

Bonds rally as the Fed signals possible rate cut

Fixed Income Team

Bonds rally as the Fed signals possible rate cut

  • Global growth is set to moderate amid trade rifts and waning business confidence.
  • We predict the Fed will cut interest rates by the end of 2019.
  • China and the United States reach a tentative peace accord on trade.

The global economy has cooled in 2019 as the fallout from the ongoing trade rifts, waning business confidence, and financial market volatility have kept the lid on expansion. Despite multiple headwinds, we expect growth for the remainder of the year will hover around its long-term trend of 2% to 3%. The U.S. economy is also likely to expand at a more moderate pace compared with 2018. Still, unemployment has touched multi-decade lows, inflation remains anchored, and the likelihood of a recession remains low.

The Federal Reserve struck a more dovish tone in its June policy statement, and chair Jerome Powell said that the case for easier monetary policy had strengthened. We predict the Fed will cut its policy rate by 50 basis points by the end of 2019. The central bank had raised short-term rates four times in 2018, taking the federal funds rate to a range of 2.25% to 2.50%. The Treasury yield curve has been flattening for some time. The yield on the benchmark 10-year note — widely used in setting borrowing costs for consumers and businesses worldwide — fell below 2% for the first time since November 2016.

At the G-20 meeting, President Trump and Chinese President Xi Jinping made headway on stabilizing tariffs as they continue to work on long-term trade issues. At the same time, the European Central Bank (ECB) opened the door to interest-rate cuts for the eurozone. The elections for the European Parliament in May shook up domestic politics in a few countries, including Germany and Italy. And Britain is in the middle of choosing a leader to become the country's next prime minister amid a failure to agree on options for its withdrawal from the European Union.

U.S. economy set to moderate

The U.S. economic expansion is cooling from last year under the weight of the Trump administration's restrictive trade policies, economic slowdowns in Europe and China, and fading stimulus from the tax cuts of 2017. The Fed's Powell said in June that the central bank "will act as appropriate" to sustain economic expansion, fueling market speculation of a rate cut this year. The economy grew at a 3.1% annual rate in the first quarter of 2019, after expanding 2.2% in the fourth quarter. The Fed now expects growth of 2.1% this year, down from the 2.3% rate it forecast in December 2018.

Meanwhile, job creation remains solid despite some uneven gains this year. The pace of hiring rebounded in June following the sharp decline in May. The government reported that employers added 224,000 jobs, exceeding economists' expectations. The jobless rate ticked up slightly to 3.7% as more Americans looked for work. Still, there has been some pullback in the manufacturing and retail sectors. And wages are increasing, but not at a faster rate. We remain cautious about the outlook as it would not take much to tip the economy into a weaker path.

Fed rate cut in the cards

U.S. and international financial markets rallied on Fed statements that it may lower interest rates in the near term. Powell said the "case for somewhat more accommodative policy has strengthened." This represents a shift after the central bank raised short-term rates four times in 2018, taking the federal funds rate to a range of 2.25% to 2.50%. At the same time, the Fed balance sheet will continue to be reduced through September 2019. That balance had ballooned to $4.5 trillion under its quantitative easing policies during the financial crisis.

The Fed may cut rates at its meeting on July 30–31. The Treasury market is already reflecting an environment of falling rates, slowing growth, and lower inflation. The yield on the 10-year Treasury traded around 2.00%, while the two-year yield fell to around 1.75% at the end of June 2019. The spread between the two-year yield and the 10-year yield, a popular gauge of the curve's steepness, has narrowed but has yet to invert. Bond yields move inversely to prices. History shows that an inverted yield curve, where shorter-dated bonds yield more than longer-dated ones, typically presages a recession.

ECB mulls fresh stimulus

The eurozone's economy is at risk from global developments and inflation remains low despite years of unprecedented stimulus. But with interest rates already at a record low and an inflated balance sheet, the ECB has limited policy tools to boost growth. In June, the ECB pledged to delay the time frame before any rate increase to the middle of 2020. Policy makers are now mulling additional monetary stimulus, including a reduction in the already negative policy rate. The central bank has already rolled out a new program to stimulate bank lending; the targeted longer-term refinancing operations (TLTRO-III) will provide loans to banks starting in September 2019 and ending in March 2021.

The recent political shift has also dampened the region's reform agenda and growth prospects. In the United Kingdom, Germany, Italy, and France — powerhouse economies in the region — voters have shown increasing support for nationalists and populist parties. German Chancellor Angela Merkel, Western Europe's longest-serving head of government, will not seek a fifth term when her current term expires in 2021. Germany's economy, the largest in Europe, has slowed as global growth cools, Brexit drags on, and trade tensions linger between the United States and China.

China's next move

China, the world's second-largest economy, has stepped up fiscal stimulus and monetary easing to cushion its cooling economy. This includes billions of dollars in infrastructure spending and tax cuts for companies. The country's growth pace is easing amid the fallout from the trade rift and slowing investments at home. The government is targeting growth of 6% to 6.5% this year, a deceleration from 6.6% in 2018 and 6.8% in 2017. We don't expect China to return to the rapid rates of growth that supported global demand in the years following the financial crisis. Meanwhile, Premier Li Keqiang reiterated in July that the government will not competitively devalue the yuan.

At the G-20 summit in June, Trump said he would set aside plans for new tariffs on Chinese imports and also ease restrictions on Huawei, the Chinese telecommunications giant, by allowing it to buy technology that isn't deemed a security risk. China, in turn, agreed to buy more U.S. farm goods. However, current high trade barriers — including 25% tariffs on some of China's exports to the United States — will remain in effect until both sides are able to renegotiate a trade deal.

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The global economy has cooled in 2019 as the fallout from the ongoing trade rifts, waning business confidence, and financial market volatility have kept the lid on expansion.