Covenant Weekly Market Synopsis for March 22, 2019

March 25, 2019

Last Week Today. The U.S. announced it would maintain tariffs on Chinese imports for the “foreseeable” future to enforce the terms of a trade deal, but later appeared to backtrack (or clarify) that not all tariffs would remain in place after a deal is struck. Lighthizer and Mnuchin head to China this week to continue negotiations and additional meetings are planned for next week in D.C. | Following Wednesday’s FOMC meeting the Fed left rates the same and changed their forecast from two rate hikes to no rate hikes in 2019 (which, as discussed below, may be too little too late to avoid a recession). | FedEx cut 2019 earnings forecasts, citing slower global economic growth, which comports with fundamental economic data that has u-turned from synchronized growth to synchronized slowing. | The European Union fined Google €1.5 billion for “anti-competitive behavior.” The fine illustrates the U.S. is not the only country trying to protect local companies from foreign competition and, also, that U.S. corporations are not immune from being on the receiving end of the broader nationalist movement.

After building gains early in the week, global markets gave it all back and then some on Friday with most developed market indices ending the week with modest losses as global growth concerns returned to center stage. First, the Federal Reserve downgraded growth forecasts for 2019, which was followed by U.S. and German manufacturing data releases, that while expansionary, missed consensus expectations for the second consecutive month. In light of slower expected growth, and an increasing likelihood that neither the Fed nor the European Central Bank (ECB) will move forward with plans to tighten monetary policy, sovereign debt yields fell. The yield on the U.S. 30-year “long” bond declined to 2.88% (a fourteen-month low), while the yield on the 10-year German bund went negative (first time since 2016) as the gravitational pull of the Financial Crisis wreckage and subsequent missteps by the ECB prove challenging to escape.

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Fed Meeting Summary. The FOMC held their second meeting of the year last week. Investors and economists expected a dovish outcome, which the Fed delivered. Below are the highlights:

  • Fed members’ latest interest rate forecasts (i.e., the “dot plot”) shifted from a tightening bias in December 2018 (blue line) to slightly lower interest rates in 2019 (yellow line) as highlighted in the chart below.
  • GDP projections declined to 2.1% in 2019 and 1.9% in 2020.
  • The Fed will begin reducing Quantitative Tightening (QT) in May and end QT in September. As such, the Fed will start large-scale reinvesting of maturing Treasury bonds on its balance sheet this Fall. The reversal of QT will see a dramatic increase in Fed Treasury purchases. According to FTN Financial, under the previous plan the Fed would have purchased $18.1 billion from September through December of this year, but now will buy between $110 – $120 billion.
  • The Fed continues to struggle with allowing inflation to rise above 2% consistently. Per Chair Powell “I don’t feel we have convincingly achieved our 2% mandate in a symmetrical way….It’s one of the major challenges of our time to have downward pressure on inflation.” While I appreciate his frustration, the Fed missed an opportunity for higher inflation by raising rates too quickly in 2018 when growth was accelerating.

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Too Tight. Another, and an arguably very critical, section of the yield curve inverted on Friday when the yield on 10-year bonds (2.439%) fell below that of three-month Treasuries (2.442%). The actual inversion followed Friday’s weak manufacturing data in Germany and the U.S. causing longer-term bond prices to rally (and yields to fall). Yield curve inversions are worth paying attention to, particularly between intermediate and short-term bond maturities, because they have a real economic impact. Since banks generate profits by borrowing-short-term money and lending for more extended periods, inversions can curtail credit creation. When the cost of capital is higher than the return on capital, it simply doesn’t make economic sense to loan money to people and businesses, setting up a positive feedback loop in which credit creation (the lifeblood of a growing economy) is choked off. The inversion doesn’t signal a recession is imminent as previous recessions were preceded by this portion of the yield curve being inverted for at least 10 days, but there is no doubt the Fed took note as it is another indication that the market believes monetary policy is too tight – i.e., the Federal Funds interest rate is too high.

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Sources: Bloomberg Financial, L.P. and Covenant Investment Research

If the yield curve doesn’t revert to a positive slope shortly, the Fed will need to make a decision. Do they cut interest rates by 25 – 50 bps quickly to remove the 1 – 2 rate hikes the market believes were excessive from last year, or do they tempt fate and hope the market comes around to the Fed’s perspective that the current level of interest rates is appropriate? If it’s the latter, and the Fed is wrong, history indicates a recession is likely in the next 140 to 487 days (Bianco Research). The indicator is not specific enough for timing the market, but it is an excellent reminder to be vigilant in your asset allocation and ensure your portfolio is positioned appropriately relative to your risk tolerance for higher volatility ahead.

Be well,

Justin