Concerns about yield curve, recession and EM as Fed raises rates

Megan Greene, global chief economist at Manulife Asset Management, also thinks the outlook is likely to turn increasingly dovish. “I don’t think they will be able to hike that much,” she says, referring to a fourth rate hike this year, and three more next year. Most of all, the Fed is likely to be worried about the yield curve. Markets look at the spread between 10- and two-year US Treasury yields to confirm that the economy is in a healthy state. The Fed closely studies the spread between the 10-year and three-month yields (see Chart 1).

“They are all getting flatter. The Fed is really worried about inverting the yield curve because it has been correct in predicting the last seven recessions, and there were two occasions when the yield curve inverted but we didn’t go into recession,” Greene says.

In August, a paper by the Federal Reserve Bank of San Francisco discussed the concerns around a flattening yield curve. “Although the US economy is in a sustained expansion and many economic indicators show continued strength, concerns about a possible recession have emerged. One reason is the narrowing spread between long-term and short-term Treasury yields,” write Michael D Bauer and Thomas M Mertens, authors of the FRBSF’s economic letter dated Aug 27.

Long-term yields have stayed relatively low partly due to quantitative easing (QE), and partly due to US dollar strength. “You could argue the long end has gone down partly because, since the global financial crisis, the tail risk has been deflation and not inflation. A good equity risk hedge is long-term debt, so a lot of investors have gone into long-term debt,” Greene says.

EM stress a by-product of rising rates

Yields on 10-year US Treasuries have also stayed low because of rising demand from global investors as an unintended consequence of US dollar strength. This has led to weakness in emerging market currencies. EM corporates and governments have issued significant quantities of US dollar debt (see Chart 2). Four countries stand out in EM forex weakness — Argentina, Turkey, Russia and South Africa. In Asia, Indonesia’s currency has weakened significantly, posing problems for its developers, who have borrowed heavily in US dollars. Ironically, because of EM currency contagion, there has been a flight to quality.

In addition, the US dollar has strengthened this year because the renminbi depreciated by some 8%. Although the People’s Bank of China stepped in to stabilise the renminbi in August, it has stepped back and is allowing market forces to take their course. “The PBOC can argue that China doesn’t have a current account surplus for the first time in 20 years in 1H2018 and it can argue that the currency can be weaker, and driven by market forces, to justify stepping away from propping up the renminbi,” Greene says.

EM debt is not a concern for the Fed currently, she adds. “The Fed doesn’t really care what goes on in EMs except when it affects US growth prospects or there is an EM debt crisis and that could blow back to the US.”

Hence, Greene expects dollar strength to continue, with the EM currency-debt contagion also continuing.

Elsewhere, the FRBSF attributes the flattish 10-year yields to a hangover from the QE years. It says: “Long-term yields, particularly the term premium component, are significantly depressed due to QE programmes by central banks around the world and the large balance sheet of the Federal Reserve. Much empirical research suggests that QE likely had quantitatively large negative effects on long-term rates and that some of these effects are still present and continue to push down the long end of the yield curve. If long-term yields are still low because of QE, and if these effects contribute to the yield curve flattening but do not increase recession risk, then some part of that flattening may not be worrisome at all.”

The reason for rising short-term rates is “quirky” and politically driven. Supply has been rising, largely owing to the policies of the current administration. Its hefty tax cuts and fiscal stimulus is being financed by short-term Treasuries. “We’ve increased supply in the short end and that reduces prices and pushes up the yield, so that causes the short end to go up,” Greene says. The current administration still has some spending programmes that have not been implemented, the most famous of which is to build a wall along the border with Mexico.

“We’ve got a lot of stimulus going. Most of it hits in the first three quarters of this year, and should have petered out by the end of next year,” Greene says. The administration may want another stimulus going into 2020, which is an election year. “If you think the Democrats are going to win the house, they will be obstructionists, and stimulus programmes will be very difficult to pass. There is talk of a new tax bill and it will be difficult to pass,” Greene says.

“Even if the reasons for the yield curve inverting don’t imply a recession, most investors and consumers believe yield curve inversion means recession,” she points out. If investors and consumers expect a recession and behave accordingly, such as selling equities and starting to save, then a recession could be a self-fulfilling prophecy.

Disrupting global supply chains an unknown

Greene outlines two concerns over the trade war: growth and inflation. Of the two, inflation is the lesser of the two concerns. When extra taxes are imposed on components that are used to manufacture consumer goods such as mobile phones, tablets, washing machines and other white goods, prices of these goods should rise, fuelling inflation. Tariffs on consumer goods have not been experienced by Americans for a couple of generations. However, there is also the Amazon effect, where companies are worried about passing on prices to the end user because they will lose market share.

In order to maintain market share, companies are likely to give up margins, earnings and cash flow. Hence, the bigger impact of tariffs is likely to pressure corporate earnings growth rather than inflation. “The Fed also thinks that the impact will be on the growth side. Disruptions to the global supply chain are the most pernicious piece of this trade war and it’s the first time this has happened since we’ve had such a globalised supply chain,” Greene says.

The Federal Open Market Committee’s statement is also interesting. “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2% inflation objective. This assessment will take into account a wide range of information, including measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments,” the FOMC said.

The words in the statement show the Fed’s willingness and ability to react to changing conditions, Rieder of BlackRock says. “Their decisions will clearly influence some of the near-term softness in interest-rate-sensitive parts of the economy, such as housing, autos (through auto finance) and small business lending. Our guess is that [Sept 26’s] words, and this Fed’s high degree of pragmatism, will suggest a desire to go slow and be reactive to all conditions in the domestic and, tangentially, the global economy, and the Committee will likely be deeply sensitive to what its words and future actions may do in a world where the future is more unpredictable: post-QE, post-tax-bill-induced stimulus, post-mid-term elections and potentially changing political conditions, and what impact all those factors will have on future employment and inflation conditions.”