Fixed Income Outlook  |  Q1 2019

Global growth outlook cools amid higher interest rates and market volatility

Fixed Income Team

Global growth outlook cools amid higher interest rates and market volatility

  • The U.S. economy will likely slow in 2019 as higher rates and policy uncertainty take a toll on sentiment and investment.
  • China and the United States wrap up trade talks in Beijing in a bid to ease trade war.
  • Global bond yields will continue to rise, posing headwinds for financial markets.

The outlook for global growth in 2019 has slipped because of rising real interest rates, trade tensions, and asset market volatility. The U.S. economy is likely to expand at a more moderate pace compared with 2018 as the impact of the 2017 tax cut fades and interest rates trend higher. Still, unemployment has touched multi-decade lows, inflation remains anchored, and the likelihood of a recession remains low.

We believe global interest rates will continue to drift higher in 2019. The Federal Reserve raised short-term rates in December, taking the federal funds rate to a range of 2.25% to 2.50%. Market volatility and the resulting tighter financial conditions have led the Fed to shift recently to a more flexible and dovish tone. Across the Atlantic, the European Central Bank [ECB] left rates unchanged and ended its multi-trillion bond-buying program. Trade disputes between the United States and China escalated and ebbed. President Donald Trump and Chinese President Xi Jinping agreed to hold off on further tariffs until March 1, 2019, to allow time to negotiate a trade agreement.

Fixed-income markets were mixed in the fourth quarter of 2018. The risk appetite for fixed-income sectors waned amid turmoil in U.S. and global equity markets. Short-term Treasury yields rose, and longer-term Treasury yields fell. The widely watched spread between two- and 10-year Treasury yields narrowed to around 21 basis points at the end of 2018. We expect global and U.S. sovereign fixed-income yields to trend higher by the end of 2019. The Fed seems to be at a pause at the moment, considering whether to continue the path of rate increases or to slow the pace or pause.

U.S. economy set to cool

Falling stock prices, weakening global growth, and concerns about President Trump's economic policies have set investors on edge and prompted warnings that the U.S. economic expansion is nearing its end. Indeed, the U.S. economy is heading into 2019 with slowing momentum. Our central scenario is for economic growth to moderate to its pre-2018 range this year amid higher interest rates and shifting fiscal and trade policies. Buoyed by government spending and tax cuts, the U.S. economy grew at a 3.5% annual rate in the third quarter of 2018, after expanding 4.2% in the second quarter. Unemployment has touched multi-decade lows, inflation remains anchored around 2%, and the likelihood of a recession remains low. The labor market remains strong as hiring improved and wage gains accelerated. The unemployment rate was 3.9% in December 2018.

Fed Chair Jerome H. Powell acknowledged at the December rate-setting meeting that the economy is showing signs of "softening." The central bank lowered its 2019 growth forecast from 2.5% to 2.3%. The risks to growth remain asymmetric. Indicating this softening, the Institute for Supply Management's (ISM) closely watched manufacturing index tumbled in December 2018.

In addition, there is little evidence of the kind of rise in corporate investment that would be necessary to keep growth strong in the absence of fiscal stimulus. Investment has been underperforming, and forecasts for investment spending are slipping. We are left with the very real risk that the Fed will be too aggressive, placing too much weight on the labor market — which is at best a contemporaneous indicator — and not enough on the erosion of the economy's prospects.

Fed ready to pause?

The Fed raised its benchmark rate four times in 2018. The federal funds rate can slow the economy because it closely ties to consumer debt, home equity lines of credit, and other adjustable-rate instruments. The Fed is also gradually reducing its $4.5 trillion balance sheet following a decade of quantitative easing. Financial markets remain on edge, and investors are starting to bet the Fed could reverse policy as growth slows and start cutting rates before the end of 2019.

The Fed seems to be struggling a bit to get its message across. In December, Fed officials signaled two rate hikes in 2019 before capitulating to volatile markets. Powell said in January that low inflation would allow the Fed to be "patient" in deciding whether to continue raising interest rates, a message welcomed by jittery investors. It's clear the Fed is beginning to take seriously the issues that are now worrying the markets: weaker global growth, the widening consequences of the China-U.S. trade war, and financial market volatility.

Falling long-term bond yields are a sign that bond investors expect the economy to slow. Higher rates also create headwinds for fixed-income assets. The yield on the benchmark 10-year note traded around 2.69%, while the two-year yield held at around 2.48% at year-end 2018. Bond yields move inversely to prices.

ECB's interest-rate conundrum

The eurozone's economic indicators continue to disappoint. Growth is slowing, inflation is below market expectations, and domestic consumption remain sluggish. The core inflation measure watched by the European Central Bank rose by 1.1% year on year in December, the same as in November and in October, defying ECB expectations that it would be moving up by now. With the overall economic outlook not changing very much, it is looking more and more likely that 2019 will pass without an interest-rate hike by the ECB. The central bank ended its quantitative easing (QE) program in December. Starting this year, the ECB bond buying will happen in the form of reinvesting funds from maturing bonds it holds.

In addition, the eurozone's reform agenda and growth continue to struggle against a difficult political backdrop. Political stresses are becoming more evident in places such as France, Spain, and Italy. These stresses keep bubbling up, reflecting popular dissatisfaction with the status quo. There were protests in France over higher taxes on diesel and gasoline. In Spain, the success of the far-right party Vox in Andalusia (southern Spain) elections sent shock waves through the country's political establishment. Italy continues to contend with high debt levels and a shrinking economy. In December, the European Union reached a deal with Italy on its 2019 budget, which allows the eurozone's third-biggest economy to avoid disciplinary action.

China's cooling economy

China, the world's second-biggest economy, is slowing amid deleveraging and trade tensions with the United States. Beijing has stepped up efforts to ease monetary policy and bank lending restrictions to lift growth. We believe the authorities have the policy tools, including control of the currency, to offset shocks to the economy. China's currency, the renminbi, had depreciated to its weakest level in a decade against the dollar in October 2018 amid worries about trade tensions and domestic growth. The yuan appreciated slightly in January 2019, fueled by hopes that China and the United States will reach a trade deal and the U.S. Fed may halt interest-rate hikes.

China and the United States wrapped up three days of trade talks in Beijing in January 2019. So far, both parties have given few details about the outcome. The Sino-U.S. trade war creates policy options for the Chinese government. China can calibrate what kind of concessions they are prepared to offer with an eye on the domestic economy. However, as the economy gets bigger and more sophisticated, the policy challenges will mount. And the chance of a policy mistake will rise. China's government is used to having control over the economy and being able to fine-tune economic outcomes as closely as they fine-tune political outcomes. But their ability to do this is shrinking over time.

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The outlook for global growth in 2019 has slipped because of rising real interest rates, trade tensions, and asset market volatility.