The sharp rally in Treasuries raised questions regarding the health of the U.S./global economy and future Fed policy
The March FOMC meeting was more dovish than expected, with no projected rate hikes in 2019 according to the median participant forecast
Yield curve inversion became a greater area of focus as March progressed, with a favored Fed metric inverting for the first time in the current cycle
The general tone in risk markets improved notably in Q1 2019, but cracks in this bullishness began to surface toward the end of March. A sharp decline in Treasury yields began immediately following the March 20 FOMC meeting, which was more dovish than expected, and weaker global economic data and geopolitical concerns further fueled an increase in Treasury prices and implied rate volatility in the ensuing days. Additionally, the 3-month/10-year Treasury yield spread inverted for the first time since mid-2007. On the data front, preliminary readings on March manufacturing PMI data from Europe were much weaker than expected, particularly for Germany, and U.S. data for both services and manufacturing came in below expectations. The U.S. manufacturing reading was the lowest since June 2017, and the March decline in the service sector survey erased much of the gains from the prior two months. Geopolitical risks from Brexit have also contributed to a bullish tone in Treasuries, creating a snowball effect.
The move in Treasuries was not mirrored in risk markets. U.S. equities were slightly higher amid the bond rally and credit spreads were only modestly wider (investment-grade credit spreads actually tightened). Nevertheless, a sharp move in government bond yields for less than obvious reasons raises questions in broad markets of whether bond investors are pricing for a larger paradigm shift (i.e., canary in the coalmine). While the front-end of the yield curve (2yr-5yr) has been inverted for much of the last four months, the 3-month/10-year inversion sparked fresh concerns of what the move may be signaling. Most market participants are well aware of the correlation between curve inversion and recession risks, and fed funds futures and OIS markets are now pricing two 25 bps rate cuts by the end of 2020. From a monetary policy perspective, recent discussions centering on “inflation targeting” have further fueled speculation that a rate cut may be the next move by the Fed, despite recent FOMC forecasts (more on that below). The concept of average inflation targeting involves allowing inflation to run “hot” above the target rate (2%) to offset periods of below-target inflation. In other words, would the Fed reverse one or more rate hikes in order to stimulate above-target inflation?
The Policy Pivot
Perhaps the greatest catalyst for the rebound in market sentiment in 2019 has been the Fed’s policy pivot that began in early January. Just one month before, Fed leaders were defiant in the face of heightened market volatility and much external criticism, particularly from the White House. At the December meeting, the FOMC raised the fed funds rate and, more importantly, maintained its guidance for continued rate hikes in 2019 and beyond. Equity markets deteriorated further before the FOMC capitulated in January and began using the word “patience” with regards to future policy decisions. Moreover, the Fed also suggested an earlier than expected end to balance sheet reduction, and at the March 20 FOMC meeting, the Committee announced plans to end principal roll-off in September.
The more surprising element of the March 20 meeting was the updated Summary of Economic Projections (SEP). More specifically, the median participant forecast for the fed funds rate now shows no rate hikes in 2019, down from 2 hikes in the December 2018 SEP. The March SEP also showed a 20 bps reduction in the median forecast for 2019 GDP to 2.1%. While markets were expecting a more dovish tone, the lack of projected rate hikes in 2019 was the initial catalyst for the multi-day rally in Treasuries.
Yield Curve Inversion
As noted above, there has been more market focus in recent days/weeks on yield curve inversion, as participants attempt to interpret the implications of the change in rates and curve slope. The 3-month/10-year inversion was widely noted, but another important measure of curve slope highlighted in the last year by Fed staff members was also noteworthy. In June 2018, Eric Engstrom and Steven Sharpe of the New York Fed wrote an article titled “(Don’t Fear) The Yield Curve,” in which they discounted the usefulness of far-term yield spreads, such as the 2-year/10-year spread, at gauging market expectations for Fed policy and, consequently, the high historical correlation of inverted yield curves and recessions. Alternatively, the article opined that a “near-term forward spread” was more intuitive choice in assessing these factors, and the metric used was a 3-month Treasury bill (T-bill) versus an 18-month forward T-bill curve. The authors noted that “using forward rates should help identify more precisely than yields where on the maturity spectrum the signal for recession lies,” and at the time it was published, this “near-term” curve showed no signs of inversion risks, unlike more popular “far-term” metrics.
In the days following the March 20 FOMC meeting, this near-term forward spread inverted. The authors admitted the limitations of their analysis in predicting recessions, including the concept of “reverse causality”, because metrics such as this may only “impound expectations that market participants have already formed.” To that end, the recent inversion could lead to several conclusions. For example, fixed income markets could be pricing in Fed rate cuts in anticipation of a pending recession. Alternatively, the expectation for rate cuts could relate more to expectations of rate cut as the Fed attempts to “unanchor” inflation expectations (i.e., inflation targeting). How will Fed leaders respond to market expectations? The median fed funds forecast in the March SEP called for no hikes in 2019, but there was a projected hike in 2020, suggesting Fed leaders aren’t quite ready to throw in the towel on the current tightening cycle…
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