A lot has changed in the market since November, and not just the relentless pounding that stocks have been subjected to for the past two months as one hedge fund after another has been liquidating ahead of year-end even as the most shorted stocks (coughteslacough) continue to levitate. Nowhere is this change more visible – aside from asset prices of course – than in the latest BofA FX/Rates sentiment survey which saw a sea-change in opinions in just one month, when after 32% of respondents expected higher rates and a flatter curve in November, this number has since tumbled to just 13%, with the majority of investors now expecting little changes to rates after Powell’s recent dovish commentary.
It’s not just subjective surveys that expect little to no rate hikes in 2019: the market itself has now priced out any additional Fed tightening in 2019, in stark refutation to the message from the Fed’s dot plot, which suggests at least three more rate hikes next year.
Indeed, as IIF’s Robin Brooks observes, going into next week’s FOMC meeting, the market “looks very dovish”, and while the December rate hike is almost fully priced in, less than one rate hike is priced for 2019 (a total of 40bps through Dec 2019), while the market expects the Fed to begin cutting rates in 2020 when the next recession is expected to begin.
Market pricing into next week’s Fed meeting looks very dovish. While the Dec hike is close to fully priced (19 bps), less than one hike is priced for 2019 (only 40 bps cumulatively through Dec-2019) and cuts are priced for 2020. pic.twitter.com/5gphlUCT7v
— Robin Brooks (@RobinBrooksIIF) December 16, 2018
So while traders are certain the Federal Reserve will hike rates this week, the key question and the “suspense” centers on the latest forecasts for interest rates – i.e., the dots – and the economy, which have profound implications for one of the biggest debates in the Treasury market.
The Fed’s final projections for 2018 will come as investors are rapidly souring on the economy and losing confidence that the Fed will keep hiking amid as global economic headwinds hit the US economy.
And, in what could become a self-fulfilling prophecy, strategists say they are exclusively focused on the Fed’s outlook for 2019, which will dictate whether the inversion seen in some parts of the yield curve becomes more pervasive. With 2s5s and 3s5s recently inverting and sparking much discussion of imminent recession, the spread between 2- and 10-year yields is already close to going negative for the first time since 2007.
In this context, what Powell says next week will have immediate consequences for the shape of the yield curve and whether the 2s10s inverts.
According to Ian Lyngen, head of US rates at BMO – who has been calling for a flatter curve for the past year – the curve’s next leg is likely lower: Lyngen believes that Powell will probably sound more upbeat on the economy than markets anticipate as he justifies raising rates, potentially sending risk assets sliding even more as stocks have recently priced in a substantial pullback in rate hike odds. Should policy makers confirm plans to hike three more times in 2019, and leave the dot plot unchanged, that will only add to the flattening impulse.
“The real risk will be that the Fed doesn’t change the dot plot, increases fed funds and sounds generally kind of hawkish,” Lyngen told Bloomberg. “That would be a surprise, because I think consensus is now a dovish hike. So if we get a hawkish hike, that will flatten the curve even further.”
And with the 10Y closing Friday at 2.89%, and the 2s10s at just 15bps, Lyngen expects the gap to narrow to the “low single digits” on a hawkish surprise Wednesday if the dots are unchanged, suggesting 3 more hikes in 2019. The result is a rising prospect of curve inversion, “potentially within weeks“, which in turn has drawn the attention of investors and policy makers as an inverted curve has almost always resulted in a recession.
Said otherwise, just one misplaced dot on the next dot plot, and the curve may invert just in time for Christmas.
Looking further out, the spread between December 2018 and December 2019 eurodollar futures, an indication of how much tightening the market expects in 2019, has shriveled to 10 basis points, implying less than one-quarter point hike. Should the Fed push back against this dovish market sentiment, it is likely that we will see a violent squeeze as dovish ED positions are unwound, resulting in even tighter financial conditions, and an acceleration in the stock selloff.
Still, most expect Powell – who was taught a painful lesson by the market for his Oct.3 comments that the neutral rate of interest is “still a long way away” – to fold to the what has been dubbed the “Dow vigilantes” (and, of course, Trump who last week said he “hopes” the Fed won’t hike any more). One among them is Bryce Doty of Sit Investments Associates expects the Fed to shift its forecasts lower, soothing markets, even though strong U.S. economic data should have Powell sounding optimistic. Yet even though Doty anticipates a lower 2019 median dot, he still foresees curve flattening because a quarter-point hike would push short-end rates higher.
“That will be the only possible source of relief for stock investors,” said Doty. “They’ll say, ‘Okay, he’s really bullish on the economy, but at least we got some good news on the dot plot.'”
On the other hand, if the Fed refuses to budge on its 3 hike forecast for 2019, with the median 2019 dot remaining at 3.1%, or 3 rate hikes higher…
… then all bets are off, especially for Powell’s career because should the Fed chair be seen – by Trump – as responsible for the next stock market plunge, then his odds of staying employed as Fed chair will be roughly the same as the Fed hiking next year.
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