As Fed Meets, Virus Scare Continues
The FOMC rate decision comes later today (2pm ET), and while you can never call a Fed meeting inconsequential, this one is about as close as you can get. No rate change is expected and there will be no update to their rate and economic forecasts so the only information provided will be the post-meeting statement and Chair Powell’s press conference. The market consensus is that the Fed will continue to characterize the economy as strong with a positive outlook given the trade deal with China, and Brexit moving towards the next chapter. The virus scare may not get mentioned in the statement but a press conference question will surely be asked. The virus outbreak introduces a new uncertainty into the Fed’s calculus, but it’s too early to consider altering policy so expect Powell to reflect that view in the presser. In any event, we’ll be back this afternoon with a recap of the meeting.
The beginning of the year has established new trends in several different financial markets that goes against the pattern experienced in the fourth quarter of 2019. We take a look at some of those trend shifts and discuss whether they are brief counter-moves or indeed lasting changes from what we experienced in the second-half of last year.
- The first trend has to be the rally in Treasuries and the renewed flattening of the yield curve. While the biggest driver to the rally has been the safe-haven trade stemming from the coronavirus outbreak, the ease with which it has happened is instructive as well. While consensus opinion had news of the phase one trade deal with China providing a bearish impulse to Treasuries, the upward move in yields was very modest and never really challenged the 1.95% level on 10yr notes that has been support since October. While some giveback of the rally appears likely, when the virus threat recedes, one wonders if 2% is a legit target anymore; especially, given some of the other trends that have emerged this month.
- Commodity prices have taken a real header this month, led by the decline in oil and a turnaround in the dollar. The oil drop, the dollar increase and the commodity decline are all interrelated but the net of it is that any inflationary impulse that might have come from dollar weakness and commodity price strength that characterized the fourth quarter has abated, if not reversed. In the fourth quarter the Thomson-Reuters Commodity Index increased 7.5%, led by a 17% increase in oil. Meanwhile, the dollar dipped 2.6%. So far this month the commodity index has fallen 6.6%, oil is down 13% and the dollar is up 1.7%. The real import of this trend change, if it holds, will be to dent inflation expectations that may have been encouraged by the fourth quarter price action, and that is indeed what we’re seeing in inflation breakeven rates.
- In addition to the popular CPI and PCE inflation series, we like to watch the 5yr and 10yr inflation breakeven rates from the TIPs market. These breakeven rates are investor inflation expectations over the holding period of a Treasury Inflation-Protected Security (TIPs), determined by the price paid for said security. In the fourth quarter, both the 5yr and 10yr inflation breakeven rates rose. The 5yr went from 1.35% to 1.72% at year-end while the 10yr went from 1.52% to 1.80%. In January the upward trend has broken, in large part due to the aforementioned trend change in commodity prices and the dollar. The 5yr TIPs breakeven rate is 1.60% and the 10yr 1.66%. The downward trend has been a constant this month.
- The moves this month in rates, commodities, and the dollar probably deserve a pause and a bit of consolidation/reversal, but if the underlying trend in commodities and the dollar holds, don’t expect the correction in yields and inflation to retrace the entire 2020 move. Indeed, after a brief respite the new trend could very well continue.
TIPs Inflation Breakeven Rates Shift Lower in 2020
As we mentioned in the previous section, the safe-haven trade driven by the coronavirus scare certainly deserves the lion share of the credit for the recent move lower in yields. Investors, however, would be advised to see that other factors working on yields lurk just behind the virus headlines. Indeed, the shift down in inflation expectations could be a longer-lasting force that limits yield back-ups, and if the downward trend continues it may encourage the Fed to consider rate cuts sooner rather than later if the 2% inflation target appears to be fading.
Part of the explanation for the shift in the inflation trend is the aforementioned discussion on commodity price declines, along with renewed dollar strength after a period of weakness in the fourth quarter. Both of those developments work to diminish inflationary impulses and as such the downward move in inflation breakeven rates followed as a consequence.
The point to be made here is that while the safe-haven bid from the virus scare has been a major driver in lower yields, there are other forces afoot that, if the early 2020 trends persist, could limit yield increases once the news improves on the virus front. Fed funds futures don’t foresee a full 25bps rate cut until November but if the disinflationary trend persists the odds of an earlier rate cut will undoubtedly increase.
Agency Indications — FNMA / FHLMC Callable Rates
|Maturity (yrs)||2 Year||3 Year||4 Year||5 Year||10 Year||15 Year|