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Fed manages to surprise gloomy bond market
By: The Financial Times | March 20, 2019

Central bank’s assessment points to some unease over the outlook for growth and inflation

Stock markets have enjoyed a welcome recovery this year, even as the government bond market has been signalling that the global economy is losing momentum. On Wednesday, the Federal Reserve sided with the latter.

Global equities have gained 12 per cent in 2019 — the best start to a year in two decades. Yet government bonds have rallied, with the yield on the 10-year US Treasury now close to the level it was at when the Fed began lifting rates in 2015.

After raising rates four times in 2018, the Fed’s top brass have in recent weeks played down the prospect of any more as they begin to voice a caution about the economic outlook that has been prevalent in the debt market for months. But even bond investors were surprised by the outcome of Wednesday’s meeting, when officials cut their forecast for US growth, abandoned projections for rate rises this year and said they would stop offloading their bond holdings by September.

“I didn’t think they’d do it, but they came across as more dovish than what was expected,” said Brian Jacobsen, a senior investment strategist at Wells Fargo Asset Management. “Wrapping up the balance sheet run-off by the end of September rather than the end of December was the biggest surprise.”

It was enough to pour extra fuel on the fixed-income rally, sending the yield on the 10-year Treasury, a benchmark for corporate borrowing costs, sliding. It was down a couple of basis points at 2.51 per cent in early trading in London on Thursday, dragging German, French and Italian yields with it. Bond yields move inversely to prices. Unsettled by the Fed’s more hesitant tone on the economy, the S&P 500 closed 0.3 per cent lower and European equities were subdued.

At the heart of the dive in bond yields is a combination of robust demand for safer government debt, even when returns are paltry, and deep-seated scepticism among many fixed-income investors that the global economy will emerge from its soft patch and a confidence inflation will remain subdued.

Some reckon this week’s Fed meeting may be the prelude to the first rate-cutting cycle since the financial crisis. Bob Browne, the chief investment officer at Northern Trust Asset Management, argues the US central bank was wrong to raise interest rates in December — a mistake that he feels should be reversed as soon as possible.

“They were responding to the current data, and not where the economy will be in a year’s time,” Mr Browne said. “A pause was a good start, but let’s also unwind the mistake of the December rate hike.”



Given that many economists still expected the Fed to keep one rate increase pencilled in for 2019, Mr Powell did his best at the subsequent press conference to stress that the central bank still thought growth was reasonably strong, but the two-year Treasury yield — the most sensitive corner of the US government bond market to monetary policy — tumbled 7 basis points to below 2.4 per cent, while the 30-year yield dipped below 3 per cent again. Investors are now pricing in a 40 per cent chance of a rate cut by the end of the year, up from about 25 per cent earlier this week.



Easier monetary policy might be beneficial to equity markets as well, but in reality the calculus is more complicated.

The European Central Bank also sprung a surprise earlier this month, changing its forecasts and reviving a crisis-era bank lending programme for banks. However, after an initial jump, European stocks sagged as investors fretted about the ECB’s pessimism.

Banks, which benefit from interest rate increases, led the declines in both cases. However, if the ultimate message of central banks and the bond market — that global economic growth is slowing sharply — is correct, then more problems could lie ahead.

“Both markets are reading that the economy is in more dire shape than headlines would have made you think,” said Michael Mullaney, head of research at Boston Partners.



The extent of the bond market’s concern can be seen in the so-called yield curve, which is made up of Treasury yields of various maturities. The two-year US government bond yield was as much as 7bp higher than the five-year Treasury yield — the most since 2007. The benchmark 10-year yield was just 13bp above the two-year, close to the inversion that is a classic omen of a coming recession.

While equities are hardly trading at giddy levels, the divergence between what stock and bond markets were signalling is stark and one of the two might have to give, said David Riley of BlueBay Asset Management. Unfortunately, stocks could lose out in either scenario.

“If the Fed was cutting rates, then I suspect the world would be looking a lot worse and I think risk assets would sell off pretty heavily,” he noted. “If equities are right then there’s going to have to be a re-rating in the fixed income market, and that could be a source of volatility.”


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