2019 Brings Lower Yields, Higher Volatility
A brief period of rate stability early in the year was dashed in March, and the only constant since then has been uncertainty, with market participants seizing on any opportunity to confirm their bias for lower rates. To date, the two-, five-, and ten-year Treasuries have each shed 70-80 bps of yield, fully inverting the yield curve in anticipation of similar declines in the Fed funds rate.
US Economic Data
While the pace of economic growth has certainly slowed this year, the majority of the economic data released so far this year does not support expectations for a recession in the near-term. Concerns over weak first quarter growth were fortunately not backed up by the data, with 3.1% growth registered during the quarter. However, the expected moderation in growth now appears to be occurring, with current estimates of second quarter GDP in the mid 1% range.
As we entered the year, some slowdown in the labor market seemed likely as the tight US labor market makes it a struggle for employers to fill empty positions with qualified applicants. However, the labor market has continued its streak of monthly job gains without a negative print, extending that record to the current mark of 104 months.
Although monthly payrolls data have been a bit erratic, job creation this year has averaged 164k new jobs per month, a level which is more than sufficient to accommodate new entrants to the work force. Despite this lofty streak, two of the last five months have seen job gains below 100,000, leaving some observers seeing cracks in the labor market’s façade.
Other economic indicators have been mixed. On the positive side, the robust labor market has kept unemployment low and provided support to wage growth. As a result, consumer spending and consumer confidence measures remain strong. The picture is less sanguine for the country’s manufacturers and homebuilders, leaving consumers the sole driver of economic growth in the near term.
Increasing Trade Tensions
The on-again, off-again trade negotiations with China have persisted throughout the year and are seemingly no closer to a conclusion than they were in January. As additional tariffs have been put in place in the interim, the economic damage to the economy is real, and growing. In May, the Trump Administration raised existing tariffs on $200 billion worth of imports from 10% to 25%. This follows the imposition of tariffs on more than $250 billion of Chinese goods in 2018.
According to research performed by the New York Federal Reserve, the 2018 tariffs cost the average American household $414 per year. The newly imposed tariffs are expected to increase that annual cost by $831 per household. The strong labor market has allowed consumers to overlook the additional costs; however, it seems only a matter of time that the tariff impacts provide a measurable impact on consumer spending and sentiment.
Monetary Policy and Fed Communication
As the economy has shifted into lower gear, the related Fed policy shift has played out in fits and starts as the FOMC slowly backs away from its forecasts of additional increases in the Fed funds rate. With the labor market still firing on all cylinders, the Federal Reserve’s traditional policy driver is the level of inflation (as the Federal Reserve’s mandate is to ensure full employment and stable prices). Recent declines in US price levels have been explained away as anomalies by Fed policymakers. The lack of inflation has been one of the biggest puzzles for policy makers, as the tight labor market would generally result in wage pressures and higher spending by US consumers, pushing prices higher. However, that has not occurred in any material way this economic cycle, leaving the Fed without one of the key touchstones to guide the development of monetary policy.
That process has also been thrown a monkey wrench by the challenges of responding to the potential economic instability introduced by the increase in trade tensions and resulting tariffs. The addition of political tensions has not made the Fed’s job easier, as the Administration has made clear it favors a preemptive approach to lower interest rates to ensure that the economic expansion continues.
Fed Chair Powell surprised markets with a speech in early June in which he indicated that the FOMC would “act as appropriate to sustain the expansion”, repeating that phrase once again following June’s meeting. These comments have been interpreted to mean that the Fed could cut rates if they believed escalating trade tariffs (or some other risk) imperiled US economic growth. If those comments truly reflect a departure from the Fed’s previously stated data dependent approach to setting monetary policy, they would lay bare another poorly choreographed change to FOMC policy.
Recession Concerns Multiply as Schism Between Markets and Data Grows
Despite the mostly robust economic data received during the first half of the year, the dramatic decline in rates demonstrates the market’s fear of an oncoming recession. As the charts below indicate, recession indicators based upon the labor market and economic activity show virtually no risk of an oncoming recession. Similarly, consumer sentiment paints a bright picture of expected economic activity. However, the shape of the yield curve now indicates a nearly 30% chance of a recession in the next twelve months.
Outlook for Interest Rates
As term rates have already declined so significantly this year, there appears to be little room for them to fall further barring a collapse in US economic activity. Longer-term rates are nonetheless likely to remain under pressure as long as the clouds of slower global growth, increasing trade tensions, and political uncertainty hang over the economy.
The gap between Fed funds and term rates has increased the range of possible paths for Fed funds, with significant differences in rate forecasts emerging among economists. The Federal Reserve’s final Open Market Committee meeting of the first half ended as planned, with the Committee slightly downgrading economic expectations and lowering rate projections. The Fed now appears to be setting the table for a rate cut, with Chairman Powell stating that “the case for somewhat more accommodative policy has strengthened.” As a result, short-term interest rates have declined and are unlikely to recover in the near-term barring a turnaround in global growth and/or international trade talks (which could presage a more patient monetary policy position).
Similar to the situation entering the year, a wide range of interest rate expectations can create potential value in investments with embedded options which reflect that uncertainty. Examples of securities with embedded options are mortgage-backed securities and callable securities. The current challenge is capturing that additional compensation in structures which will maintain their duration should interest rates decline further.
An additional opportunity is presented by the shape of the yield curve. From an interest rate risk (IRR) perspective, the best value proposition exists in the short end of the yield curve, as investors are not compensated for extending duration. More specifically, shorter-duration investments with variable rate coupons tied to short-term indices, like one- or three-month LIBOR, provide very attractive yields in relation to their IRR. Current yields for floating rate CMOs, for example, are 1 month LIBOR plus 35-40 bps, which is a yield of 2.75-2.80%. Non-amortizing floating rate instruments are also available, generally at single-digit spreads to one-month LIBOR. The primary risk of shorter-duration investments is that the economy deteriorates more rapidly than expected, forcing the Federal Reserve to reverse course and begin cutting short-term rates. However, the significant nominal pickup in yield offers some protection as short-term rates would have to decline at a rapid rate to erase the additional yield picked up in the short term.
Despite the relative unattractiveness of longer-duration fixed rate products, the decision to extend duration may provide value from an IRR perspective in terms of protecting income in future periods. However, it may result in declines for short-term NII/NI forecasts.
The correct strategy is one which provides your credit union sufficient income in a range of rate scenarios. In contrast to previous years, a “base case” rate scenario is much closer to an unchanged to -50 bp yield curve. In the midst of the rising rate environment over the past few years, a +50 to +100 bps scenario was more likely to approximate the near-term interest rate environment. Now that the Federal Reserve has shifted their focus to the downside risks to the economy, it is prudent to prepare balance sheets for declines in interest rates driven by a more conciliatory Federal Reserve.
Please reach out to your Accolade investment consultant with any questions you may have.
VP – Chief Investment Officer
VP – Strategic Advisory
Senior Balance Sheet Adviser
Investment advisory services offered through Accolade Investment Advisory, LLC, a registered investment adviser.
This material represents and assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or guaranteed future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. Past performance is not a guarantee of future results.