This overconfident market faces FOMC disappointment
Senior Fixed Income Strategist, Saxo Bank Group
Summary: The European Central Bank’s Mario Draghi waxed extremely dovish yesterday and the market therefore expects the Federal Reserve’s Jay Powell to follow suit tonight and lay out the path for a US rate cut next month.
As a matter of fact, we don’t believe that data are as bad as they seem. There may be reason to loosen monetary policy when considering inflation as it is well anchored or even trending lower. However, other data indicate that a rate cut might be premature. For example, unemployment is near its natural rate and wages are still supported. In addition, we must remember that there is still uncertainty surrounding how tariffs will impact inflation, which makes an argument for the Fed to be more patient and wait for more data.
Instead of cutting interest rates the Fed might use other tools such as tapering the quantitative tightening to end its balance sheet reduction, thus allowing time to wait for more data and delay interest rates cuts. After all, if you can only cut interest rates eight times from current levels, you don’t want to waste this tool when you don’t really need it.
We believe that if the Fed sounds as dovish as the market expects it to be and prepares for a rate cut as early as next month, this can only mean that the Fed has lost operational independence and is meekly toeing the White House line or that it has more information than the market has regarding a deterioration of the economy.
Either way, the news is not going to be positive and the fixed income market will react to both outcomes.
After the rally in US sovereigns the biggest problem at this point is that if the Fed does not deliver on market expectations there could be a sell-off, especially in the shortest part of the yield curve. We believe that the Fed will use neutral language to avoid provoking volatility in the market. However, if investors suspect that three rate cuts are not realistic, we can expect some adjustments in bond valuations.
If that were to be the case, we believe that the shortest part of the curve would rise faster than the longer end, due to the fact that while investors would keep their investment in the longer part of the curve due to fears of a trade war and uncertainties regarding foreign policy, especially a confrontation with Iran, the short-term part of the curve at the moment is uniquely linked and dependent on central bank monetary policy. This might be the last element that may provoke the very much feared inversion of the US yield curve.
While in both scenarios of very dovish or mildly dovish Fed we believe that investment grade corporate spreads will be supported by investors, while junk issuances would be very sensitive should the Fed fail to live up to the market’s expectations.
Indeed, as we can see from Figure 2, the rally in treasuries in the past few days pushed riskier assets to tighten faster than higher-quality bonds. High yield corporate spreads now are trading at levels previously seen at the end of 2016 when the economy was in a better shape and pointing towards a recovery and Fed tapering was just starting to be discussed.
We believe that at these levels there is not much convenience in hunting for yield in the junk space for the simple reason that there are too many things that can go wrong: policy expectations not matching the Fed decision, trade war developments and high leverage in the system. As we have mentioned many times, opportunities can still be found but it is important that investors stay cautious and pick up only selected names in the high yield space, while focusing on the IG space for the greatest part of their portfolio.
There may be opportunities arising from higher quality junk bonds if their values correct in case the Fed disappoints, especially when looking at short-term maturities. However, we believe that it does not make sense to pick up risky assets for less than 150 basis points over Treasuries at this point in time as it is still possible to find investment grade corporates offering such return.
For example, Sprint with a coupon of 3.36% and maturity September 2021 (US85208NAA81) is offering a yield of 3% which is 100 bps over Treasuries. Similarly, General Motors with a coupon of 3.2% and maturity July 2021 (US37045XBM74) also offers 3% in yield with an even shorter maturity. If trade tariffs don’t scare investors, then the issuance of Ford that we have highlighted in earlier articles with a coupon of 3.336% and maturity March 2021 (US345397XW88) offers a yield of 3.20%, 125bps over the treasuries for just one year and nine months risk.
Latest Market Insights
Quarterly Outlook Q3 2022: The Runaway Train
- Central banks' attempts to kill inflation is a paradigm shift, which could end in a deep recession.
Tangible assets and profitable growth are the winnersWith US equities officially in a bear market, the big question is where and when is the bottom in the current drawdown?
Understanding the lack of investment appetite among oil majorsThe everything rally seen in recent quarters has become more uneven, as its strength is driven by commodities in short supply.
The pressure is on as the wind leaves the sailsWith cryptocurrencies in sharp decline, are we entering a crypto winter or is the bear market a healthy clean-up of the crypto space?
Why the Fed can never catch up and what turns the US dollar lower?Many other central banks are set to eventually outpace the Fed in hiking rates, taking their real interest rates to levels higher than the Fed will achieve.
Bank of Japan: Swimming against the tideThe Japanese economy has gone from the age of deflation to rapidly rising prices in no time, leaving the Bank of Japan in a pickle.
Green transformation detour and bear market hibernationWith the impending risk of global econonomic derailment, we share the five things investors need to consider in this new half year.
Crisis redux for the eurozone?Whether there's going to be a recession in Europe or not, the path towards a stable economy will be agonizing.
Technical Outlook: Gold, Oil and a remarkable multi-decade perspective on EquitiesThe Nasdaq bubble pattern, USDJPY resistance, crude oil uptrend losing steam and the technical outlook for USD.
China: the train of new development paradigm left the station two years agoChina is transiting to a new development paradigm, as they are hit by deteriorating terms of trade, a slower global economy and an uncertain future while continuing attempts to contain the pandemic.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)