The Fed’s in waiting mode

Grid with arrows increasing and decreasing

With a third of the year over already, much of the market volatility encountered in late 2018 is fading in the rear-view mirror. While the China trade dispute has reemerged recently as a top risk for investors, markets are still generally positive for 2019. Brexit and uncertainty about future Fed policy likely remain number two and three on the list, but investors appear to believe all are manageable over time.

Along with reduced market volatility have come impressive U.S. economic data. Despite a few minor hiccups early in the year, Gross Domestic Product (GDP), employment and inflation all registered at better than expected levels over the first few months of 2019.

The generally good economic data have dampened concerns about an “inverted” yield curve that were much in the news back in March. Recall that when short term interest rates are higher than long rates for more than a few months, this can signal impending economic weakness. This condition prevailed for several weeks, and (bearish) market commentators couldn’t stop harping about it. Near the end of the first quarter, though, rates resumed their normal posture, with the 10-year Treasury rate back above the 2-year. This coincided with better economic data, and the yield curve bears went back into their caves. That said, it’s important to monitor this “spread” for signs of a U.S. recession. Right now, there are few.

One of the key drivers of the brief inversion in rates had been the big decline in the benchmark 10-year yield. It fell from a high of 2.75% in early March to a low of 2.36% at the end of the month. This almost two-year low in rates was precipitated by several factors.

First and foremost, the Federal Reserve announced at their March meeting that further interest rate increases are off the table. According to their statement, they are patiently “data dependent” – meaning they will allow the flow of economic data to determine policy, rather than raising rates on “auto-pilot” as they did during 2018. Money markets adjusted quickly to this change, and Fed Funds futures now place greater odds on a cut in rates by year end, rather than an increase.

The second factor driving U.S. long term rates down in March was general economic weakness outside the U.S., particularly in Germany. Historically the engine of the European Union, the German economy remains weak, and their markets remain mired in negative interest rates. This is noteworthy, because investors worldwide were under the impression in early 2018 that the extraordinary steps taken in the previous decade to resurrect the EU were working, and negative interest rates were about to end. Alas, this was just a pause. The European Central Bank is once again pushing interest rates into negative territory in Germany and much of the Eurozone. As European investors search for positive returns, (positive) U.S. Treasury rates look more and more attractive. This tends to drive our rates lower as well.