LONDON (Reuters) - The outlook for U.S. interest rates has shifted, as investors bet that recent cracks in the economy and financial markets will force the Fed to slow or even halt its projected path of rate increases next year.
All else being equal this should also be playing out in the bond market, pushing down long-term yields and easing financial conditions, thereby helping to limit the fallout from a weakening economy and fragile stock market.
Yes, yields have come down a bit, but not as much as you would expect, thanks to a steady build up of factors that should push them the other way.
October was the worst month on Wall Street in seven years, the so-called ‘FAANG’ group of top five U.S. tech stocks lost almost $1 trillion in market capitalisation, Apple skidded into a bear market, and some U.S. economic indicators - namely the housing market - began to flash red.
If growth slows at this stage of the economic cycle, the chances of recession rise and the Fed puts the brakes on, or maybe even reverses gear all together. The all-knowing, all-seeing bond market should discount that, and yields should fall.
Fed chair Jerome Powell on Wednesday suggested that interest rates are already close to neutral, the level that neither accelerates or restricts the economy. His comments pushed the 10-year yield to its lowest since September.
Only one quarter point rate hike next year is fully discounted in money markets, compared with two a couple of months ago. But the 10-year yield remains above 3.00 percent, barely 20 basis points off its peak in early October just before the Wall Street lurch and “tech wreck”.
A growing risk for markets and the economy is that it holds that level and starts trending higher again.
10-year U.S. Treasury yield: tmsnrt.rs/2PZ33LP
Emerging markets, which are most exposed to U.S. borrowing costs and the dollar, will be vulnerable. The stickiness of Treasury yields and the dollar hovering close its highest since June last year aren’t good signs.
Record supply, high hedging costs, the Fed unwinding its balance sheet and emerging markets potentially selling Treasuries to support their domestic currencies is a potent mix that could easily keep the 10-year yield above 3.00 pct, even if the historically long economic and market cycles roll over.
The Treasury market’s demand and supply balance is looking increasingly short on demand and long on supply. As Luke Gromen at research firm FFTT notes, there’s a race going on: will investors’ demand for a port in any coming storm be enough to offset that widening imbalance?
Gromen calculates that the Treasury will roll over as much as $8 trillion of debt next year and issue $1.3 trillion in new bonds. In addition, the Fed has already started winding down its portfolio.
That’s a lot of paper for the private sector to buy, especially as the current level of U.S. yields makes it prohibitively expensive for foreign investors to hedge bond purchases.
U.S. bond auctions - direct bidders: tmsnrt.rs/2Q5zQyZ
U.S. Treasury holdings: tmsnrt.rs/2PZhLSW
Fed policy may be too tight already, even before the three or four rate hikes that would take the fed funds rate up to what the Fed still officially considers the “neutral” rate of interest around 3.00 pct.
In a recent blog published in the Washington-based Council for Foreign Relations, Benn Steil and Benjamin Della Rocca say balance sheet reduction and rate hikes have already tightened monetary conditions beyond neutral.
“This suggests that monetary policy will start to contract economic growth early next year,” they conclude.
Few people think the U.S. economy faces recession next year, far less is already in one. But it’s worth remembering that by the time the Fed slashed rates in late 2008, the economy had been contracting since December the previous year.
Most economists think policy is still accommodative and, if anything, the risk is not that the U.S. economy slows but it overheats. This will keep the Fed tightening and put natural upward pressure on yields.
The general view is still that the 10-year yield hits 3.50 pct before 2.50 pct. If it does hold above 3.00 pct and drift higher, no matter hot or cold the economy is, the Fed will have a decision to make.
By Jamie McGeever; Editing by Kirsten Donovan