Treasury yields dropped this week to a 21-month low. Multiple Fed officials spoke of the possibility of lowering short-term interest rates as ongoing trade tensions with China begin to wear on the U.S. economy. Further causes of concern include slowing manufacturing data both in the U.S. and abroad, negative interest rates in Europe and Japan, and the European Central Bank opining on the high probability of rate cuts in the Eurozone to combat its sluggish economy.
At the moment, there are several conflicting economic signals: consumer and business confidence is strong, but other key economic data are showing signs of a potential recession on the horizon. Of greatest concern is the 3-month to 10-year Treasury curve, which has inverted. A prolonged inversion supports the notion that the markets believe rates are too high, and more importantly, it is a key recession indicator.
Further pushing bond yields lower Friday was the release of the May Jobs report which came in much cooler than expected (75,000 actual versus 185,000 estimated). Some of the weakness in hires last month could be blamed on worker shortages in certain sectors such as construction. It will be interesting to see how the June jobs report plays out. A tepid June jobs report will all but guarantee a Fed rate cut. Due to the Fed Funds Rate already at a very low level relative to the length of the economic recovery which dates back almost 10 years now, the Fed has very little room to lower short-term rates and it will act sooner than later once it believes economic growth is stalling.
Speaking of rate cuts, corporate and individuals are enjoying lower borrowing costs and lenders are aggressively pricing home and commercial loans in the search for new business. With so many experts expecting lower rates to come, we continue to advise clients to be cautious as any unexpected good news (think trade deal with China) could catch markets off guard. For the moment, we are biased toward floating rates at these levels with the understanding the market is severely overbought.
Declining mortgage rates have spurred refinance activity, as well as increased the probability of a strong spring home buying season. With inflation in check and the Fed on pause, interest rates should remain attractive for the foreseeable future. However be on the alert as rates may have bottomed and hit resistance in moving lower after rallying greatly since the beginning of the year.
Fears of global economic activity slowing continue to weigh on bonds. The recent drop in rates has pushed several wealthy nations debt to trade at zero % or below. In the U.S., the 10-year Treasury bond briefly dropped below 2.4% this week and the 3 month to 10-year Treasury yields inverted, a potential ominous signal of a looming recession should the inversion hold. An inverting yield curve has predicted most recessions and the inversion is the result of fears of economic growth globally as well as a lack of inflation. These fears will keep investors on their toes and may create a more volatile rate environment in the coming months.
Given that we believe most of the concerns we’ve mentioned are priced in, we are biased toward locking in rates at these very attractive levels. Any unexpected good news could move rates up higher quickly.
The highly anticipated Fed meeting this past Wednesday did not disappoint. The Fed went “max dovish” in their policy statement by stating no more rate hikes for 2019 and possibly only one rate hike in 2020. Many market watchers actually believe the next Fed move in interest rate policy will be lower, a far cry from just this past December where the Fed believed that two more rate hikes were likely for 2019. Less understood but equally important was the Fed’s timeline on the end of the balance sheet run-off, which will be ending later in the year.
Bonds responded as expected as both government and mortgage bond yields fell precipitously. Stocks responded with caution, falling Wednesday, rallying Thursday, and as of the time of this post, falling hard on Friday.
What’s next? The big question being asked is what does the Fed see that others don’t with such a quick shift in policy. Low rates will help borrowers buy new homes, cars, refinance debt, and also aid corporations, but the return of low rates due to the fear of either a brewing U.S. recession or quickly slowing European, Japanese, and the Chinese economies is quite worrisome. Longer-dated German bunds have gone negative for the first time in quite a while, and our own 10-year U.S. Treasury bond is trading at 2.45%, well below the 3.25% seen just a couple of months ago.
For those who qualify, low rates are another bite at the apple, which will help boost the spring buying season, as well as spur refinances, which will result in more savings or more disposable cash flow to buy other items, so in that sense we are grateful to the Fed.
Should the U.S. avoid recession (keep an eye on the flattening yield curve), rates at today’s levels are very attractive, but should the U.S. slip into a recession, expect rates to fall lower. At the moment, we are in a wait-and-see mode on rate direction and would not be surprised if rates were headed lower.