Sunday, June 9, 2019

May 2019 Yield Curve Update

Good news on the monetary policy front.  The Fed has been signaling a willingness to ease, and currently, futures markets are predicting a 25 basis point rate deduction in July (with some probability even of a 50 bp deduction!).  Initially, this brought the yield curve down out to several years, but in the days since then, the short end of the curve has remained lower while the curve from 2020 onward has recovered back to late May levels.  That's a great sign.  Maybe the Fed will ease enough to avoid a contraction.

The primary thing to look for in the yield curve, I think, is reaction of the long end.  I think we are clearly in inversion territory now, which means that there has been some distortion in long term yields.  As short term yields decline, that distortion will be eased, and long term yields will initially decline along with short term yields.  Eventually, the positive signal will be a divergence between short and long term rates, with a flattening of the short to mid term curve and a slight upward slope.  It seems as though the Fed is willing to be aggressive enough to make that happen.  This is a positive surprise to me.

Expectations have changed so sharply that already, if you look at the December 2020 contract on the Eurodollar curve, half of the gap between the November peak rate of about 3.2% and 0% has already been filled.  In terms of taking a long position on forward rates, the horse is already mostly out of the barn.  If the Fed is aggressive, forward rates may not have that much farther to fall.

In the second chart here, I would expect the typical pattern to happen, where, as the Fed Funds Rate declines, the 10 year rate will decline along with it along the inversion trend line.  At some point, the 10 year will stabilize.  A rule of thumb I would expect to look for is if the Fed has gotten too far behind the 8-ball, then the economy will deteriorate and the Fed Funds rate will continue to decline.  Or, if they get ahead of the ball, then the 10 year will recover.  So, I suppose I would expect the inversion to eventually reverse.  The scatterplot will cross back over the trendline.  It would be a bad sign if the scatterplot crosses the trendline horizontally and it would be a good sign if it crosses it vertically.

It moved vertically in 1996 and 1999.  But, in those cases, the curve wasn't inverted, or the inversion hadn't been in place quite as long.  In cases where it has been inverted for at least this long, recession followed.  In 2001, the inversion was reversed by lowering the Fed Funds rate, so it crossed horizontally.  It seems as though we could go either way.  I have been prepared for the mania about asset prices to drive the Fed to a too hawkish position, but the fact that the market thinks there is a chance for a 50 basis point move in July suggests that the Fed is no longer as hawkish as I thought.

1 comment:

  1. The Federal Reserve hints that it will ease and then 10-year interest rates fall... Seems to me they should rise.

    By the way, I think the global softness in equities is largely due to over-tightness by global central banks and has less to do with a trade dispute between two nations over a portion of the goods they trade.

    Recently, the ECB, The People's Bank of China, and the Federal Reserve have all made easing-type comments.

    I still think helicopter drops are the solution, but perhaps semi-conventional monetary easing will be enough.

    It still seems to me that financial media cannot grasp that central banks can be too tight even though nominal interest rates are low by recent historical standards. There may still be some of the tight-money crowd perspective out there.

    ReplyDelete