Red-letter Fed Day
Senior Fixed Income Strategist
Summary: Equities are bleeding, gold has the blues and everybody is waiting for the Fed's interest rate decision. The future doesn't look too bright but for those seeking safety, the bond market has a few handy hurricane holes in which to ride out the storm.
A December rate hike per se this time it is not as important as the projections of rate hikes for 2019. As a matter of fact, a December rate hike has been already priced in to the market, while a dovish Fed which will hike once or not at all in 2019, hasn't yet been taken into consideration. This is why it is necessary for investors to understand the Fed's intentions for the new year in order to position themselves.
With a dovish rate hike, investors expect the Fed to hike this month but more importantly, that Chairman Jerome Powell will deliver a message most likely implying only a single hike (if necessary) next year. This should cause a soft rally in treasuries, both in the long and short part of the curve as traders adjust to the news.
Investors have already been fleeing to safer assets in the past few months as the market didn’t give signs of recovery. As a matter of fact, we have seen the 10-year Treasury yield falling 40bps since its highest in November and German bunds retreating to 0.24%. And to make things worse, there's news on every TV channel discussing the fact that this is the worst December since the Great Depression, and obviously, this isn't helping market sentiment.
The real risk we are facing today is for the market to panic even more especially if the Fed doesn’t sound confident about the economy, hence the rally in Treasuries can turn to be stronger than expected, causing a further flattening, if not an inversion in the mid part for the curve.
While the short part of the curve is already inverted with the spread between the 5-year and the 2-year yields is -0.3bps, the spread between the 7-year and 5-year Treasury yields is around 8bps at the moment. However, last week it narrowed down to 5bps, signalling that an imminent inversion is very probable.
Can the Fed meeting become the final straw that will push the mid part of the yield curve to invert? Maybe.
However, it is interesting to know that it is very possible this to happen even if the Fed decides to continue to sound confident about the economy and confirms interest rates hike for next year too. Should this happen, we believe the reaction of the market would be more vigorous and that we would see a bear flattening quickly turning to inversion as investors flee to safety on longer maturities because the equity market would react nervously to the news, and the short part of the curve would adjust upwards.
This means that an inversion of the yield curve is inevitable and if it does not happen before year end, it is something we will most probably see next year.
Therefore, a dovish rate hike will do little to calm investors, and the volatility that we have seen affecting the market until now will continue.
What can investors do?
This is the billion dollar question. Indeed, the market has not been behaving as we would expect it to. For example, amid the equity sell-off gold has gained very little steam and seems to have lost some of its safe-haven luster, as it has risen a little in the past couple of months, but not to the levels that we have seen at the beginning of the year.
In this situation, the wisest thing to do is not to engage in opportunistic trading and start to position a portfolio towards positions that would guarantee wealth preservation.
In this case, the good news is that contrary to gold, bonds appear to have become one of the most important safe havens in the market, with yields falling as the equity market falls. This implies that bonds can easily be used as diversification too in order balance off losses from equities in an investor’s portfolio.
Therefore, we would like to reiterate our message to take advantage of a flat, or possibly inverted US yield curve and lock in yield with short-term corporate bonds with maturities of up to three years and with a good pick up to US Treasuries. In these maturities it is possible to find solid names offering even 4% in yield, which considering the performance of the equity market this year, is much more than what we can expect in stocks assuming that volatility will continue to be high.
Our favourite sectors at the moment are defensive sectors and banking. Although it is important to note that it is favourable to invest in short maturities for financials, but the longer the yield curve stays flat or inverted the more the operational environment for banks will become difficult.
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