Markets are Still Fighting the Fed on Rates

Last Friday’s strong US GDP reading for the first quarter has sparked several days of debate between TwentyFour portfolio managers. The 3.2% reading was 100bp ahead of consensus, so a strong beat at the headline level, but the components accounting for it, such as inventory building, suggested the figure was an aberration and likely to reverse in Q2. It also refocused our minds on what the market is pricing in for Fed rate policy, and what it might mean for Treasury yields.

At the end of last week, markets were pricing in a 70% chance that the Fed would cut rates by January 2020. This is what was concerning us; that the market had taken the ‘Fed pivot’ narrative a little too seriously and this might be contributing to the very strong support for US Treasuries, which is unusual given the very strong rebound in risk assets so far in 2019. Correlations have so far broken down this year, and since such breakdowns don’t tend to last very long, we are keen to look deeper at the reasons for this.
We think the breakdown in correlations so far this year is justified as the fear of higher rates and a policy error became the source of risk last year, and this would need to be reversed. Treasury yields had risen to levels (3.25% on the 10-year in early November) that were no longer justified in the context of no further hikes in 2019. No more hikes also provided the signal for risk assets to rebound. This was Q1, and it all made sense. Now, though, we can find little rationale for the continued breakdown in correlations, unless the Fed is going to cut rates in the relatively short term.

This has been the crux of the debate on the desk.

Our starting point was that at 2.5% 10-year yields felt about right, given inflation and 2019 growth both somewhere near 2% and a Fed funds rate of 2.25 to 2.5%. It also felt right that Treasuries should be well underpinned this late in the cycle, with slowing growth and nine rate hikes under the Fed’s belt. Our worry was that we just could not see the Fed cutting rates in 2019 after all that they had said to clarify their stance. They were wrong in Q4 last year, and had gone to inordinate lengths to clarify where they stood today. But the market was pricing in a 70% chance that they would cut, despite not a single member of the FOMC, voting or otherwise, forecasting lower rates in 2019, 2020, or 2021.
We felt this 70% market conviction had to be having an impact across the Treasury curve. So despite our view that rates would be underpinned, we thought for the short term that yields would have a chance to drift slightly higher, particularly as there was an FOMC meeting this week and Fed chair Jerome Powell was given the opportunity to address this.
As it transpired the questions in the press conference teed him up perfectly, and Powell said quite simply the Fed would need to see a sustained period of inflation undershooting their goal before a rate cut was on the table. He even added that the recent small pull-back in inflation was, in the Fed’s view, transitory.

Interestingly enough though, while market expectations of a rate cut have reduced a little, they are still pricing in a 50% chance of a cut by January 2020. The knock-on effect on Treasuries has been small, with 10-year yields rising by around 10bp since Powell’s press conference, showing how well underpinned they are.

Our view remains that the Fed will not cut this year, and consequently there is still some vulnerability for Treasury yields in the short term if market-based expectations for a rate cut begin to dissipate.