September 30, 2019
No Shortage of Worries and Concerns
Lawry Knopp, VP-Funding & Hedging
U.S. Treasury yields remain near the bottom of their one-year trading ranges as market uncertainty remains elevated. Over the past 30 days, U.S. Treasury yields have moved higher with the two-year yield up 12 basis points to 1.62% while the 10-year is yielding 1.68%, an increase of 18 basis points. The three-month/10-year slope of the Treasury curve is inverted as the three-month yield is near 1.82%. Over the past year, the trading range for the two-year yield is 1.43%-2.97%. The 10-year trading range is 1.46%-3.24%. The low for both the two-year and 10-year occurred about a month ago.
The list of concerns is growing as recent attacks by Iran on Saudi Arabian oil facilities increase the prospect of conflict in the Middle East and greater uncertainty related to oil prices. In the meantime, the U.S.-China trade war has intensified, the outlook for global economic growth remains weak and the U.S. economy appears to be losing momentum. The risk of a recession within the next 12 months remains elevated and there are signs of weakness in the economy as job growth slows.
Typically, increased market uncertainty exerts downward pressure on interest rates; however, there are technical factors in play as we head into year-end that may add volatility to the interest rate outlook, especially short-term rates. Over the past couple weeks, the Federal Reserve has been busy adding liquidity to short-term funding markets to calm recent spikes in overnight interest rates. The need for increased liquidity is related to several factors. Most recently, the need for cash increased as quarterly tax payments needed to be made to the government while dealer balance sheets were saturated with recent corporate and government debt issuance.
Normally, investment dealers accumulate cash from investors during the time between trading a new security and settlement (delivering cash to the issuer). However, during periods of rising interest rates, it can be much more difficult for investment dealers to sell securities to investors because the value of the securities compared to new trades goes down as interest rates go up. This means the dealers are forced to hold the securities on their balance sheets longer than normal, which ties up cash.
A couple weeks ago, the need for cash increased significantly as the banks and dealers needed to settle trades, despite still holding the investments on their balance sheet. Around the same time, tax payments to the U.S. Treasury were due.
Quantitative tightening, the process of the Federal Reserve reducing the size of its balance sheet, has also contributed to the environment of tighter liquidity. The Fed’s balance sheet expanded significantly during the Great Recession as policymakers flooded the market with liquidity spur growth and maintain calm in the financial markets. Quantitative tightening began in October 2017. Another factor contributing to reduced market liquidity is the Dodd-Frank legislation, enacted in 2010, meant to reduce risk taking on the part of banks and other financial entities.
After several days of providing liquidity, demand has subsided and injecting cash into the banking system appears to have been successful. However, it’s too early to determine if the Fed has done enough to prevent a repeat of volatility in short-term rates as we move toward year-end.
The monetary policy statement by the Federal Open Market Committee following its two-day meeting in mid-September indicated the committee believes the most likely outcome for the economy is continued growth, strong employment and moderate inflation. However, the committee did acknowledge “uncertainties about the outlook have increased.” Policymakers continue to watch developments in financial and international markets, as well as progress on a potential trade deal with China. Recent comments from officials indicate the potential for one more 25-basis-point rate cut by year-end, likely in December. From the market’s perspective, the Fed needs to cut rates by 75 basis points over the next several months to sustain the current economic expansion.
A look at the overall economy indicates business spending and housing slowed in the second quarter, along with net exports and inventories. However, stronger consumer spending offset much of the weakness from other components of GDP. Looking ahead to the third quarter, the narrative is expected to reverse as consumer spending takes a breather and business spending and housing take up some of the slack. The boost from housing will likely be temporary as mortgage rates are expected to move higher. On a year-over-year basis, the economy has expanded by 2.3%. Market forecasts call for the 2020 GDP growth rate to be around 1.8%.
There is modest upward pressure on inflation despite trade and tariffs headlines. Pressure on food prices are being offset by lower energy costs. Also, service costs have weakened lately, but this will likely turn around next year. Look for the year-over-year inflation rate to be steady the rest of the year. Depending on economic performance, we could see inflation trend higher in 2020.
Job gains are expected to be choppy over the coming months, which increases the impact of potential shocks to the labor market. This could come in the form of reduced trade or a weakening in consumer confidence while some blame the slow job growth on fading fiscal stimulus. A jump in the unemployment rate would likely signal an end to the current record-setting expansion. Nevertheless, job openings continue to exceed the official number of unemployed and weekly claims for jobless benefits remain low. An economic downturn will likely be preceded by a substantial decline in job openings and sustained increase in claims for jobless benefits.
Despite unrest in the Middle East, oil prices are relatively stable, notwithstanding the recent attack on Saudi Arabia’s oil facilities by Iran and efforts by OPEC and its allies to trim production and push prices higher. The one-year trading range for WTI crude is $45 to $73 per barrel, with the current price indicated near $56 per barrel.
The dollar continues to remain near the top of its trading range as U.S. performance exceeds most major economies and U.S. interest rates remain higher than many developed nations. The dollar is expected to retain its strength as European and Asian central banks contemplate expanding monetary accommodation to foster economic growth.
Eurozone weakness is expected to continue while the European Union works through weaker demand, slowing inflation and a messy Brexit. The European Central Bank recently cut its monetary policy rates, dropping the overnight rate by 10 basis points to -0.50% and resumed quantitative easing with a program of buying 20 billion euros worth of debt stimulate growth. The Bank of Japan is projected to ease policy rates in October in response to a scheduled Oct. 1 VAT tax increase.
View on Interest Rates
Two FOMC meetings remain this year. The Federal Reserve is expected to leave rates unchanged at the October meeting and ease policy rates by 25 basis points at the December FOMC meeting. In October the Fed could announce plans to strengthen liquidity leading into year-end and establish a new facility aimed at increasing the overall level of reserves. If economic conditions were to weaken, the Fed may ease policy rates by 25 basis points at both meetings, depending on trade developments and global financial conditions. Look for longer-term Treasury yields to remain near current levels until the risk of recession begins to recede and inflation expectations rise.
A resolution to trade issues between the U.S. and China could significantly improve the global economic outlook and bring the perspectives of Federal Reserve policymakers and the market much closer together. The prospect of a lingering trade war without any progress on a trade deal will likely further weaken the global growth outlook and hasten more policy easing by the world’s central banks.
The above commentary is a summary of select economic conditions prepared for Northwest FCS management. It is being shared as a courtesy. As with any economic analysis, it is based upon assumptions, personal views and experiences of those who provided the source material as well as those who prepared this summary. These assumptions, conclusions and opinions may prove to be incomplete or incorrect. Economic conditions may also change at any time based on unforeseeable events. Northwest FCS assumes no liability for the accuracy or completeness of the summary or of any of the source material upon which it is based. Northwest FCS does not undertake any obligation to update or correct any statement it makes in the above summary. Any person reading this summary is responsible to do appropriate due diligence without reliance on Northwest FCS. No commitment to lend or provide any financial service, express or implied, is made by posting this information.