By Marvin Loh, Senior Global Market Strategist, BNY Mellon
With this round of major central bank meetings behind us, our key takeaway is the belief that most policymakers want to continue along the normalization path.
This includes a rate hike from both the BOE and BOC, along with strong messaging from the Fed that it will continue to push towards further rate hikes. While the ECB is far from any type of hawkish bent, it is still on target to stop expanding its balance sheet at the end of the year.
Even the BOJ, which attempted to dovishly reassure the market that it was committed to its QE policy, has taken a slightly hawkish tilt on how to approach yield curve control and the pool of assets that it would subject to negative yields.
The problem for the central banks is that investors are generally skeptical that they will be able to even approach a normalization of monetary policy. For instance, in addition to raising rates last week, the BOE presented the specter that there will be more forthcoming. OIS levels, however, indicate only one more BOE hike by the end of 2019, taking liberties with the term “gradual”.
Even more remote are rate hike expectations for the ECB and BOJ, which have essentially stated that they are in no rush to raise rates, driving minimal rate hike expectations through 2019.
By all accounts the BOC has been the second most aggressive central bank behind the Fed, having raised rates four times over the past year, closely matching the Fed’s three hikes during this period. The BOC expects to continue to tighten conditions gradually, which the market has implied equates to three more hikes by the end of 2019.
By contrast, the Fed is messaging five additional hikes in the next 16 months, versus a market expectation of only three more during this period. From a timing perspective, Fed Funds Futures expect a hike this September and December, a pause until June 2019, before the rate hiking cycle essentially ends.
Fed Will Continue to Push in 2018, Inverting the Curve
With this as a backdrop, our thought remains that the Fed is well positioned to continue its hiking campaign for the remainder of the year. Looking ahead, we think that the FOMC’s base case is also its worst case, as the funds rate is expected to exceed the neutral rate sometime in 2019.
We think that the continued flattening of the curve reflects these concerns, which we observe has also been one of the most persistent and successful trades this year. While the Fed views the flattening trade as largely driven by technical factors, we think an inverted curve will prove a challenging conundrum to manage. In particular, while the flattening curve has not yet impacted economic growth, an inverted curve can act as a catalyst in slowing economic activity.
We therefore do not expect a significant spike in longer yields, even as the 10-year again flirts with the 3% level. We still view overall inflation and wage data as well behaved and think that a meaningful uptick is needed in order to drive the Fed to reach its stated funds goal of 3.375% in 2020.
As the attached chart indicates, the volatility in 10-year yields towards and through the 3% level has almost been entirely driven by the change in real yields. In contrast, breakevens have been essentially in a 15 bps range since the start of the year, even as headline CPI has increased by 80 bps during this period.
A look into how both real yields and breakevens have been priced given current and expected inflation environments is presented in the charts below. In particular, we track breakevens to CPI readings over the past two decades.
Looking at the current breakeven level of 2.10% from a historical average perspective, we are fairly close to both longer term (2002-present) and pre-crisis (2002-2007) levels. Further, introducing the CPI levels and the associated breakeven levels reveals a similar result that the current breakeven rate is fairly well priced, given current inflation patterns.
In terms of forward expectations, we ran a similar exercise for real yields, which shows that the current level of 85 bps is tracking below historical averages, providing the specter of rising yields. Parsing these results with forward inflation expectations (as represented by the 5y5y forward rate), however, narrows this range.
In particular, the current 5y5y is 2.45%, which has corresponded with an 80 bp average yield in the past. From this perspective, real yields are fairly priced given forward inflation expectations. The 5y5y level has also not changed much this year, even as the Fed has largely reached its symmetrical inflation expectation.
We think the Fed has wordsmithed these concerns from the policy statement, as it recently changed the following language: “Market-based measures of inflation compensation remain low; survey-based measures” to “Indicators of longer-term inflation expectations are little changed, on balance”.
Above Trend Growth and JGBs as Tail Risk
A higher and longer sustained period of above trend economic growth is needed to drive a more bearish outcome in our view. That has been the message from recent higher profile projections that expect the 10-year to hit 5% in coming years.
Again, this is not our base case as a combination of the waning impact of tax reform, one-shot fiscal stimulus, and escalating trade rhetoric will push US growth closer to potential.
We will also point to changes to the BOJ’s yield curve control program as a potential tail risk catalyst. In particular, the BOJ widened the target band for the 10-year JGB to 20 bps last week.
Following the change, yields immediately rose from low-single digits to 14 bps before settling in the current 11 bps range. We would expect traders to test the 20 bps level before long, although the BOJ has demonstrated its willingness to defend the range.
More important is the signal that the BOJ may abandon yield curve control as it has not been particularly effective at driving inflation, which was its main purpose.
As the attached chart indicates, JGB yields have decoupled from Treasury yields since late fall, when investors began to price a more aggressive Fed. Movements between the two sovereign yields have been marginally correlated since before the crisis, but have recently moved into the +0.9 range.
Therefore, a spike in JGBs cannot be ruled out as a possible driver for higher US yields, although we think the flattening trend will exert a stronger influence in the short term.