Fixed Income Outlook  |  Q2 2019

Bonds rally as the Fed hits the pause button

Fixed Income Team

Bonds rally as the Fed hits the pause button

  • An inverted yield curve raises concerns about a U.S. downturn.
  • The Federal Reserve's dovish shift on interest rates has boosted Wall Street.
  • China and the United States inch closer to finalizing a new trade deal.

The outlook for global growth has cooled in 2019. Higher real interest rates, weaker demand from China, political troubles in the eurozone, and trade tensions have kept the lid on economic growth. Still, that downward trend may be easing, and we are likely to see waves of optimism and pessimism about growth in the coming months. The U.S. economy is likely to expand at a more moderate pace compared with 2018. Unemployment has touched multi-decade lows, inflation remains anchored, and the likelihood of a recession remains low.

The Fed pivoted to a dovish stance on interest rates in the first quarter, and this has reassured financial markets and prompted investors to reduce expectations of further hikes. 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 Fed has also announced a more flexible approach to shrinking its balance sheet. Across the Atlantic, the European Central Bank left rates unchanged and ended its multi-trillion dollar bond-buying program. In Britain, the government remained in crisis as Parliament failed to agree on options for the country's withdrawal from the European Union. Across the Pacific, China and the United States appear closer to a trade deal, and any truce would be a positive step for the global economy.

The U.S. Treasury market continued to draw headlines in the first quarter of 2019. Treasury yields tumbled in many parts of the yield curve as the Fed expressed a more cautious view of the U.S. economy. The slide in the 10-year bond yield has taken it below the rate on 3-month Treasury bills — a phenomenon known as an inverted yield curve and which is commonly viewed as a harbinger of recession. Despite this move, we expect global sovereign fixed-income yields to trend higher by the end of this year.

U.S. economy set to cool

The U.S. economic expansion is cooling from last year, under the weight of the Trump administration's shifting trade policies, economic slowdowns in Europe and China, and fading stimulus from the tax cuts of 2017. The economy grew at a 2.2% annual rate in the fourth quarter of 2018, after expanding 3.4% in the third quarter. Jerome Powell, the Fed chairman, said in March the economy "is in a good place." The Fed now expects growth of 2.1% this year, down from the 2.3% it forecast in December, and 1.9% in 2020.

We believe the probability of a recession remains low. We expect to see signs of weakness in areas like business investment and housing. However, the labor market remains strong, real wages are edging higher, and consumer spending is steady. After a lackluster performance in February, the job market bounced back in March. U.S. employers added 196,000 jobs, an indication that many businesses are still looking to hire despite signs that the economy is slowing. The unemployment rate held at 3.8%, according to the Labor Department.

The Fed's 180-degree turn

U.S. and international equity markets rallied after the Fed signaled no interest-rate increase this year, bringing its projections more in line with market expectations. This was an abrupt halt to what had been five consecutive quarters of rate increases. Most Fed officials now expect a single rate increase in 2020 and none in 2021. The Fed had forecast two rate rises for 2019 as recently as December. The central bank also said it will slow the monthly reduction of its Treasury holdings starting from May with a cut from $30 billion to $15 billion and will cease trimming its balance sheet in September.

Fed Chair Jerome Powell said at the March rate-setting meeting that short-term rates could be on hold for "some time" as global risks weigh on the economic outlook and inflation remains below the Fed's 2% target. The Treasury market is already reflecting an environment of steady rates, slowing growth, and lower inflation. As a result, parts of the Treasury yield curve have inverted. Falling long-term bond yields are a sign that investors expect the economy to slow. While the recent inversion in and of itself is not a forecast of a recession, it is a sign that something might be awry, and we would like to see a steeper curve. The yield on the 10-year Treasury traded around 2.41%, while the two-year yield fell to around 2.27% at the end of March 2019. Bond yields move inversely to prices.

ECB to inject stimulus

The eurozone's economy is showing the effects of both local and global developments. The region is flirting with an economic contraction, but we believe there will be some modest growth. Domestic demand appears to be holding up reasonably well. The ECB said it expects its key interest rates "to remain at their present levels" at least through the end of 2019. In March, the central bank announced a new program to stimulate bank lending in the eurozone; the targeted longer-term refinancing operations (TLTRO-III) will provide loans to banks starting in September 2019 and ending in March 2021. Financial lenders will be able to provide better credit conditions to customers, which in turn could stimulate economic growth.

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 and Italy. In addition, Brexit also poses risks to smaller countries within the eurozone that are most exposed to a breakdown in trade with the United Kingdom. A "no deal" Brexit would affect the United Kingdom and may be enough to tip the barely growing German economy into contraction. However, that is not our base case, and the latest signals from London suggest a soft Brexit is the most likely outcome.

China fine-tunes policies

China, the world's second-largest economy, has stepped up efforts to cushion its cooling economy. The latest measures include tax cuts, a reduction in corporate Social Security contributions, and an increase in local government bond sales to finance infrastructure projects. In early March, the government lowered its growth target. Premier Li Keqiang set the gross domestic product (GDP) growth goal for 2019 at a range of 6% to 6.5% compared with last year's, which was "about" 6.5%.

China's currency — the yuan — is another tool that policy makers can use to manage the economy. For years, there was global pressure on China to move toward a free-floating currency due to concerns regulators were capping the yuan's value against the dollar to benefit exporters. The yuan has stabilized so far this year. The mood on the China trade conflict has changed, and there is considerable optimism that a deal will be signed by President Trump and President Xi Jinping in the near future. Still, it's not likely the deal will provide a lasting boost to confidence and economic activity.

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