The Federal Reserve's decision to raise interest rates for the fourth time this year, while signalling further tightening in 2019, has sparked a quick reaction in government bond markets around the world and rekindled concerns of a near-term recession in the world's biggest economy.
Fed Chairman Jerome Powell confirmed a 25 basis point increase in the Fed Funds rate, the fourth of the year and the eighth in the current tightening cycle, and said "some further gradual increases" would be needed for the world's largest economy next year, defying critics who insisted the bank should examine incoming data before committing to more rate hikes. Powell also said the $50 billion a month pace of bond sales from the Fed's $4 trillion balance sheet was "smooth" and unlikely to change.
"The Fed's decision to push ahead with its fourth hike of 2018, but shave 25bp off its profile for expected hikes, has seen the US 2-10 year Treasury curve flatten further and risk assets suffer," said ING's head of strategy Chris Turner. "The 2-10 year curve is now just 10bp away from inversion and will certainly have investors stress-testing portfolios for a further slowdown in activity and perhaps even a recession."
Benchmark 10-year U.S. Treasury notes hit an 8-month low of 2.75% in overnight trading following Powell's press conference, before retreating to 2.767% Thursday, with 2-year note yields trading at a few basis points higher at 2.666%, putting the slope of the yield curve at just 10 basis points.
Fund managers are also piling cash into both government bonds and the U.S. dollar, the December BAML survey of 243 investors controlling around $700 billion in assets revealed, and are the most bearish on the global economy since the global financial crisis, with a net 53% expecting a 2019 slowdown.
Bond allocation, the survey noted, hit the highest levels since the 2016 Brexit vote, at a net 35% underweight, with the fastest month-on-month rotation (+23 percentage points) on record. Investors were also adding to cash balances, suggesting further equity market caution, with overall levels rising to 4.8% from 4.7% in the previous month.
The peculiar arithmetic of fixed-income investments basically makes short-dated bonds more sensitive to interest-rate changes. So when short-term rates spike, that means traders are anticipating higher rates from the Fed.
But when, at the same time, they're also worried about longer-term growth, they'll still buy 10-year debt, pushing prices higher and yields lower and thus "inverting" the curve.
According to a study from the San Francisco Federal Reserve, an inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
However, it's probably fair to say at this point that signals for faster Fed rate hikes -- which push the front end of the curve higher -- are likely more powerful than growth concerns that are pushing longer term yields lower, especially with Powell reiterating the Fed's aim to raise rates two more times next year.
The Atlanta Fed's GDPNow forecasting tool suggests fourth quarter growth is humming along at a 2.9% clip, an assessment that's only modestly lower from last week's tally of 3%.
That continued strength, alongside the tightest labor market since 1969 and the potential for a broad-based trade deal with China sometime over the first quarter of next year, however, has some wondering if the market's interpretation of the Fed move is correct.
"Not a single FOMC member now expects three hikes next year, compared to four in September, when one member looked for four increases," said Ian Shepherdson of Pantheon Economics. "This looks to us like a worrying case of group think; the end of 2019 is a long way away, and a trade deal with China, coupled with a surge in wage growth, is an entirely plausible outcome, which almost certainly would require rates to rise by more than 50 basis points next year."