For the world’s biggest bond market, 2019 is turning into a battleground for bets on the path of U.S. monetary policy.
Investors in recent weeks have moved closer to the Federal Reserve’s projected path of three rate hikes next year -- they’re now pricing in two, following expected increases next week and in December.
But some, including at Eagle Asset Management and Vanguard Group Inc., still doubt that inflation will be enough of a threat to warrant as much tightening as policy makers anticipate.
This divide may persist at least until November, when the results of U.S. midterm elections make it easier to gauge the potential economic tailwind from fiscal policy. The resolution of the debate over the course of interest rates could prove to be a slow meeting in the middle of the two camps. But it may also deliver a painful blow to bond bulls or even the Fed’s credibility. Either way, the standoff sets the stage for heightened turbulence in debt markets after one of the most subdued stretches in decades.
“The bond market doesn’t believe in the inflation story,” said James Camp, director of fixed-income at Eagle Asset Management, which oversees about $34 billion. “This sets up for a very interesting 2019.”
Traders ramped up bets on 2019 Fed hikes after labor-market data released Sept. 7 showed wages jumped in August by the most since the end of the recession. But Camp, for one, still isn’t convinced inflation will accelerate, a view that gained traction after unexpectedly tame consumer-price figures last week. He’s holding 10-year Treasuries and sees the Fed pausing in 2019 after two more hikes this year, starting with next week’s decision.
The market has been reluctant to price in the Fed’s projected path since this tightening cycle began in 2015, especially after the central bank fell short on delivering the multiple hikes it projected for 2016, eventually moving only once. The dynamic started to change ahead of the March 2017 tightening, when traders had to scramble to price in a hike in response to Fed signals.
Derivative traders see the funds rate only reaching about 2.8% by the end of 2020, whereas in June, the median of Fed officials’ forecast was for 3.4%.
“There’s a view that the Fed has largely converged to the market,” said Jan Hatzius, chief economist at Goldman Sachs Group Inc. “From 2012 to 2016, that was true. The period before that it wasn’t true, and the period since then it hasn’t been true.” Hatzius is among Wall Street economists predicting the Fed will tighten even faster than policy makers indicate. Goldman Sachs, JPMorgan Chase & Co. and Royal Bank of Canada all forecast four increases in 2019.
Investors, for their part, may be signaling dimming confidence in the durability of the economic expansion in the face of rising rates and trade tensions. The gap between two-year and 10-year yields last month shrank to as little as 18 basis points, and though it has widened back to around 25 basis points amid in an uptick this week in 10-year yields, the curve remains close to its flattest level since 2007. Back then was the last time the market saw a curve inversion, a phenomenon that has been a reliable predictor of recession.
“The market is starting to price in a Fed pause” around mid-2019, said Gene Tannuzzo, a fund manager at Columbia Threadneedle Investments.
Bob Parker, a member of Quilvest Wealth Management’s investment committee, predicts economic growth will level off, so the Fed “actually does very little next year.” Jerome Schneider at Pacific Investment Management Co. sees two hikes in 2019, as does Anne Mathias, a strategist at Vanguard.
Part of the reason Camp expects the Fed to stand down next year is to avoid inverting the curve.
New York Fed President John Williams has pushed back on that sentiment.
"We need to make the right decision based on our analysis of where the economy is and where it’s heading in terms of our dual-mandate goals,” he said this month. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I would find worrisome on its own."
What it comes down to is that the Fed and markets differ on when rate hikes will start crimping growth. The Fed forecasts policy becoming restrictive by the end of 2019, with the funds rate at 3.1%.
So one way or another the gap in views will have to be bridged. Fed Chairman Jerome Powell will have more opportunities to do that and head off potential market volatility starting in January, when he’ll begin holding press conferences after every meeting, Schneider said.
“The question is, is there a moment of reckoning coming?” said Robin Brooks, chief economist at the Institute of International Finance. “Will Jay Powell have to at some point stand up in front of markets and say, ‘Hey guys, you have this wrong, you need to price more out the curve.’
“But to communicate that is quite tricky because a hawkish surprise risks upsetting stock markets,” Brooks said. “And that risks upsetting some of his main constituents, including in the White House.”
