I am looking forward into 2019 at this point. And if you look at the Fed’s summary of economic projections from June, you see a median projection for the fed funds rate moving from 2.4% at the end of this year to 3.1% at the end of 2019. So that means the Fed is guiding to three rate hikes for 2019. Let’s talk about that in the context of the recent bear steepening of the Treasury yield curve
From bear flattening to bear steepening
When you look at the slope of the yield curve and short term rates are going up, irrespective of what’s happening at the long end, it’s considered bearish. But up until now, we have been in a bear flattening environment, with the short end of the curve selling off tremendously as investors move to the Fed’s stated forward guidance.
For example, a year ago the constant maturity 2-year rate was just 1.40%. A month ago, it was 2.61%. Now, the 2-year trades at 2.81%. You see a similar (though less aggressive) change for one-year paper, with the rate up from 1.31% a year ago to 2.45% last month to 2.58% now. That’s an enormous uptick at the short end.
But, the curve has flattened as 10-year rates moved from 2.24% to 2.85% a month ago to 3.06% now. The last month has been very noticeable on the long end because 10-year rates have finally moved out of the channel below 3% where they had been trading virtually all year. The curve has steepened ever so slightly to just over 25 basis points. And so, finally we are seeing Fed policy feed through to the long end. Will it last though? And how will the Fed react?
The Fed’s reaction function
I think we should concentrate on what’s happening at the short end because the bearishness comes from the increase there. And all of the action there is driven by Fed policy. When the year began, futures were predicting less than two rate hikes for 2018, whereas now the market sees an 90% probability of four.
Source: CME
Right now, I’m not quite sure what to make of the recent bear steepening. We’re only talking about five basis points though. And so I’m not convinced this is a trend.
All else equal, to the degree we see further steepening, it is more worrying from a credit cycle perspective than flattening. Why? The Fed’s reaction function and the market’s move to the Fed will play out fully on 2-year rates. So to the degree 2-year rates increase, that’s bearish. But flattening applies less pressure on debtors than steepening. Debtors would rather see the Fed’s reaction function have less impact at the long end, keeping a lid on long-term rates. But if cyclical inflation takes hold, as it is now doing, we see the pass through into long rates. And that is negative.
Looking out into 2019
I still see 2019 as the key here. Imagine that inflation worries escalate and the curve steepens more even as the Fed raises rates and the short end goes up. We could see the long end of the curve move into the high 3% range or even toward 4%. Steepening of this magnitude would be a death knell for marginal debtors.
Now, remember that the Fed’s guidance for 2019 is 3.1% by year end. The market is not there though. The market still sees only a 19% probability of Fed Funds at 300-325 basis points by October 2018. The probability of 275-300 basis points is about even odds.
If growth remains on track with inflation elevated and unemployment low, the Fed will accelerate its timetable as it has done in 2018. The differential in the Fed summary of economic projections between June and March tells you that.
Source: Federal Reserve
Rate forecasts for 2018 went up 30 basis points for 2018 and 20 for 2019 in that time frame. And now, 2019 and 2020 Fed funds rate projections are at or above the longer run ‘neutral rate’ of 2.9%.
Assuming the economy continues to power forward in the same way, we should expect the same dynamic to hold for 2019 and 2020 going forward, with the projection moving up from 3.1 and 3.4% respectively. The market is not pricing that in.
I continue to believe the Fed has been and will be more hawkish than the market expects. But only in 2019 will this start to pinch marginal debtors. In the meantime, bear steepening due to elevated inflation expectations would be worse for the market than bear flattening. And steepening would move forward the time when the credit cycle turns.
I will be very interested in seeing what the Fed’s projections are next week. I will be in the Grand Canyon all next week though. So I will give you my thoughts on the situation when I return.