What happens to US rates during a Fed pause

Macquarie’s global fixed income team conducts a Strategic Forum three times a year where we discuss macroeconomic and market views on interest rates, credit markets, and currencies with a medium-term horizon. At the January 2019 Strategic Forum, one of the team’s conclusions regarding interest rates was there is a higher likelihood for US rates to remain rangebound or even head lower as a result of the structural and cyclical headwinds facing the US Federal Reserve. As such, we believe it is an appropriate time to own US duration by increasing allocation to intermediate-term bond strategies.

Although 2018 was considered generally bearish for bonds with yields rising for much of the year, interest rates moved lower as we entered 2019. What kind of impact could that have on fixed income? We have established three potential scenarios based on our views of US rates, with the outlook likely dependent in part on action the Fed does — or doesn’t — take.

Stage is set for a potential Fed pause

Weakening global growth, low-to-moderate global inflation, tighter financial conditions, and volatility in risk markets has led to lower yields around the globe. These market conditions set the stage for the Fed to pause over the next three to six months and potentially all of 2019.

Base case: Rates stable to moderately lower (70% likelihood)

In our base case view, which we put at a 70% likelihood, we see 10-year Treasurys in the 2.60% to 2.80% range over the next three to six months. (This scenario calls for the federal funds rate and 2-year Treasurys in the 2.25% to 2.75% range.) The reasoning for this view is based on our observations of US growth continuing to ease, limited upside risk of inflation, and payroll growth that is firm, but likely to moderate. Also, tighter financial conditions would, in this scenario, cause the Fed to pause its rate hikes, although in our view rate cuts are unlikely over the next three to six months.

Base case scenario: US 10-year Treasury rate possible range

Base case scenario graph

Source: Bloomberg, January 2019.

Second case: Lower rates (20% likelihood)

In our bullish case for US rates, which we assign a 20% likelihood, risk markets would remain volatile, and tight financial conditions would persist or worsen. In response, the Fed would likely react to these market conditions through reducing or ending quantitative tightening (QT) with the probability increasing for rate cuts on the horizon. In this scenario, we see 10-year rates trending down to the 2.30% to 2.50% range over the next three to six months. (The fed funds range would be at 2.25% to 2.50%, with the 2-year Treasury at 1.90% to 2.10%.)

If volatility persists, rates could trend lower

Volatility trend graph

Source: Bloomberg, January 2019. Volatility is illustrated by the CBOE Volatility® (VIX®) Index.

Third case: Higher rates (10% likelihood)

The bearish case for US rates would require a much stronger financial and economic environment. In this scenario, there would be higher-than-expected growth and inflation in the first half of 2019, continued strong job growth, increasing wage inflation, easing financial conditions, and the yield curve flattening to the point of inversion. We view this scenario as having two to three rate hikes priced in for 2019, all of which could push the 10-year back to the recent range of 3.10% to 3.30% over the next three to six months. (This roughly equates to a fed funds rate at 2.50% to 2.75%, and the 2-year at 3.00% to 3.25%). However, we attach a low probability (10%) of this bearish case occurring over a three-to-six month horizon.

Federal funds target rate: Continuing upward?

Federal funds target rate graph

Source: Bloomberg, January 2019.

Will the Fed react? They have in the past

While the Fed hiked interest rates in 2018 and projected two rate hikes for 2019, the recent deterioration of financial conditions is making it more difficult for the Fed to continue on the path of gradual rate hikes. In our view, it’s possible that there may be one rate hike this year, but very likely that the Fed will pause its hiking cycle altogether in response to a sharper tightening of financial conditions than the Fed had anticipated. As seen in the chart below, it took the Fed just six months in 1995 to move from a rate hiking cycle to a rate cutting cycle. In 2000, it was eight months.

Probability of a Fed rate hike by the end of 2019

Expectations for rate hike graph

This chart shows how expectations for a rate hike by December 2019 have dropped in late 2018 and into early 2019.

Source: Bloomberg, Februrary 2019.

Time from Fed pause to rate cut

Feds hiking cycle graph

Historically, once the Fed halts a hiking cycle, it has not always been long before rate cuts begin -- sometimes as short as six months.

Source: Bloomberg, January 2019.

If the Fed is done, so is the flattening yield curve

One concern regarding the recent tightening cycle has been the significant amount of flattening of the yield curve. While a flat yield curve in itself does not necessarily foreshadow worsening economic conditions, the flattening could lead to an inverted yield curve, which historically has predicted recessions in previous cycles. However, when the Fed pauses its hiking cycle in the past, we traditionally have seen the curve begin to steepen as short and intermediate bonds tend to outperform longer duration bonds. So, if the Fed does pause in 2019, we anticipate that the curve would no longer flatten and may begin to steepen, favoring the intermediate part of the yield curve.

Fed target rate and the yield curve

Fed target rate and the yield curve graph

Source: Bloomberg, January 2019.

Change in yield curves following hiking cycles

Change in yield curves following hiking cycles graph

The spreads between the 2-year and 10-year, and between the 5-year and 30-year, historically have moved -- at times significantly -- when Fed hiking pauses.

Source: Bloomberg, January 2019.

A pivotal juncture for the Fed

Given the uncertainty of the current market environment, and the shifts that have occurred with bond yields, the Fed will play a key role for rates and fixed income in 2019. We expect the Fed to pause its interest rate hiking cycle, which would fulfill our moderate base case scenario, encouraging short and intermediate-term maturities to outperform. In conclusion, we believe short- and intermediate-term strategies may play a pivotal role for many investors in the upcoming market environment.


IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

The views expressed represent the Manager's assessment of the market environment as of February 2019, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Fixed income securities may also be subject to prepayment risk, or the risk that the security’s principal value may be prepaid prior to maturity at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest at a lower interest rate.

The CBOE Volatility Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. All charts are for illustrative purposes only. Charts have been prepared by Macquarie unless otherwise noted.

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