U.S. Rates Update November 2018

Monthly Commentary

December 06, 2018

Fed policy communication took center stage in November. During a much anticipated speech in late November, Fed Chairman Jerome Powell adjusted his characterization of the monetary policy rate from being probably “a long way from neutral” to being “just below” that level.

Chairman Powell’s remarks also suggested that, going forward, monetary policy could become more data dependent. When asked how the committee measured the neutral interest rate and then assessed the amount of policy tightening still needed, Powell compared the exercise to walking into that same conference room and all of a sudden the lights went out. One would then proceed with caution, feeling the way through the furniture and moving slowly. According to the Fed chairman, this is similar to what the policy committee is doing now, having tightened policy enough to be in the vicinity of the neutral rate. Putting more emphasis on incoming information could, in turn, mean that the Fed may no longer implement one hike per quarter, the pace set during 2018.

Whatever the neutral rate is, the market remains firm in its assessment that the Fed has already removed a substantial amount of policy accommodation and is only two hikes away from having completed the rate hiking cycle. Most investors therefore agree with the more dovish side of the aisle in the monetary policy committee. Currently, committee members’ “dots” – each member’s individual assessment of the long-run target level – ranges from 2.5% to 3.5%, with the majority picking 3%. At the current level of 2.25%, it is fair to say, therefore, that the level of interest rates is “just below” neutral.

Short and medium term interest rate expectations shifted remarkably during the month of November. After peaking at 3.24% on November 8, 10 year yields closed the month at 2.99%, a level not seen since September. The market was pricing in three more hikes by the end of 2019 but, by the end of the month, the estimate of policy rate embedded in the yield curve dropped to 2.75%, implying only two more hikes: one in December of this year and one more by Q4 of 2019.

The slope of the yield curve between two years and five year yields came close to zero. To the extent that it captures a more cautious view on the economy three, four and five years from now, an imminent curve inversion sparked more discussion on late cycle dynamics and whether it should be taken as a reliable predictor of imminent recession.

U.S. Treasury Yield Curve Slope
(5 year - 2 year yields, basis points)

Source: Bloomberg

Meanwhile, incoming data confirmed that the economy is still expanding at a healthy pace. The second (revised) release of third quarter GDP showed a 3.5% annualized rate of expansion. The unemployment rate remained steady at 3.7%. In line with most forecasters’ expectations, core CPI eased only slightly to 2.1%.

Summing up, the U.S. Treasuries yield curve is pricing a much more cautious outlook than that suggested by broad macroeconomic aggregates. A closer look at specific sectors of the economy can shed light on why that is the case. The housing sector is showing clear signs that higher mortgage rates, reduced affordability and perhaps implications of the tax reform are all having a cooling down effect on home buying decisions. The homebuilders confidence index fell in November sustaining its greatest monthly decline since 2014. New home sales were particularly weak, dipping 12% year over year, with months of supply rising to 7.4 versus an average of 5.5 over last six months. The credit market also showed signs that higher interest rates are beginning to spark fears of heavily indebted corporations facing challenging times ahead. Investment grade corporate spreads rose 20 bps, the highest monthly increase in almost three years. High yield corporate spreads jumped and by end of November had repriced about 100 bps higher from September. After a period of large outperformance versus stock markets in the rest of the world, the S&P 500 closed the month of November in positive territory, but is down almost 6% from its peak at the end of summer.


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