The U.S. has had an extended and very impressive rally in the prices of U.S. Treasury securities. The 10-year U.S. Treasury has seen its yield move from a recent high over 3.20 percent in early October 2018, down to below 2.20 percent at the end of May 2019.
One of the most important questions is whether the Treasury rally is signaling that a U.S. recession is imminent. While we see U.S. real GDP decelerating into the second half of 2019, we do not yet see the United States moving into an actual recession in the near future. If that read is correct, then what is driving the U.S. bond market rally?
Let's examine a multiplicity of forces impacting the market.
Unusual Shape of the Yield Curve
The U.S. Treasury yield curve has an unusual shape. At the end of May 2019, the curve is inverted, short yields above long yields from the overnight federal funds rate (at 2.4 percent) and 3-month T-bills through to the 5-year Treasury Note (just below 2.00 percent). The 5-year yield is the low point, however, and as maturities increase to 10 years and longer, yields move back to a very modestly positive slope.
When the full yield curve is flat or inverted, history has shown that more equity volatility and a potential recession may lie 12 to 24 months into the future. Market participants ignore yield curve warnings at their peril. We have certainly seen more equity volatility, but does the short-maturity inversion signal a future recession when the long maturities partially disagree?
We would go with the conclusion that the yield curve is signaling that U.S. and global economic growth is decelerating, but at this point forecasting an imminent U.S. recession seems a stretch. When the Q2 2019 U.S. real GDP data is published at the end of July, it will mark this expansion as tying the record for the longest on record. And the unemployment rate is still below 4 percent. The Fed may well be worried, but probably not worried enough to cut rates any time soon.
Subdued Path of Inflation
U.S. inflation is subdued. Persistently subdued inflation works to lower inflation expectations as well as increase the confidence that inflation risk will remain low for an extended period of time. What this means is that the spread between the U.S. 10-Year Treasury yield and the historical core (excluding food and energy) inflation rate tends to narrow as more and more market participants accept the narrative that inflation will remain subdued for a long time.
Influence of German and Japanese Government Bonds
The Bank of Japan is the king of quantitative easing. Expanding its purchases of Japanese Government Bonds (JGBs) dramatically since 2013, it has anchored JGB yields near zero. The European Central Bank (ECB), initially in the aftermath of the Great Recession of 2008-2009, chose to make emergency liquidity loans to the financial sector rather than purchase assets. This policy changed in 2015, as the ECB embraced quantitative easing, which help drive German Bund yields to converge with JGBs.
The reality for global fixed income market participants is that U.S. 10-Year Treasuries offer just over 2% more yield than similar maturity German and Japanese bonds, and the exchange rate risk has been relatively modest among the U.S. dollar, euro, and Japanese yen. Even with a little FX risk, there is a natural and powerful competitive pull from German and Japanese bond markets toward lower U.S. Treasury yields.
Escalating Trade War and U.S. Equities
The recent trade war developments have largely halted the upward momentum in U.S. equities. There has been selling pressure among stocks impacted by the trade war, as well as defensive moves into high-dividend stocks. What there has not been, at least through the end of May, is any signs of panic selling.
The Q4 2018 near-20 percent decline in U.S. equities convinced the Fed to stop its lock-step path to higher rates and shift to a policy of keeping rates on hold for 2019. So, far the Q2 2019 equity pattern is in no way powerful enough to argue for a change in Fed policy or a rate cut, even as it increases worries of economic deceleration. The Fed is clearly worried about trade war impacts on growth, but the Fed also is data-dependent. Data dependency means the Fed will probably wait to see the whites of the eyes of any slowdown in published U.S. economic data and will not move on worries or forecasts that may be misplaced.
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