06 December 2018
Flat yield curve
In turn, we have seen the Fed blink in the form of a sort of soft introduction of a ‘Powell put’ and a rally in the core bond market. The US two to 10-year yield curve has flattened to less than 10 basis points, reinforcing market concerns.
While some of those individual risk factors are clearly valid and deserve closer scrutiny, in many ways we are facing a perfect storm which has lowered US 10-year yields around 40 basis points from the recent highs.
With just 16 basis points priced in for the December hike, the market arguably overreacted as most of these drivers are a side show; the real story being the re-pricing of growth and Fed expectations from heightened levels, that had to happen at some point.
We remain convinced that US data will continue to show the country in fairly rude health and are enough to see the FOMC hike in December and twice more in 2019. The US slowdown story will take some time to unravel and existing cracks will continue to deepen. But at this point it is hard to see a recession on a 12-month horizon, with the caveat that recessions are inherently difficult to predict or even detect in real time.
The recent flattening of the yield curve is most likely due to the market pricing in an FOMC policy mistake. But if wages continue to move higher, the Fed may have little choice except to raise rates and we may see bonds and risk selling off in parallel, similar to what we saw in short periods earlier in the year.
Elsewhere, the single most likely outcome for Brexit seems to be Theresa May’s deal. No-deal probabilities have come down in recent days which leaves gilts open to some re-pricing to higher yields in most cases.
Europe is looking back on a fairly terrible third quarter and ECB President Mario Draghi will have to explain the end of quantitative easing in the face of lower GDP and CPI staff forecast next week.
Early fourth quarter data is somewhat encouraging, however, the ECB will stand ready to extend further stimulus at some point in early 2019, most likely by introducing new long-term refinancing operations and delaying the timing of the first hike.
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