Nothing Matters but the Facts! Strategic Income Outlook

The past quarter has had its fair share of market moving events, including another Federal Reserve (Fed) hike, a flattening yield curve, geo-political events and potential tariff wars. As we wrote last quarter, separating the signal from the noise remains challenging, but we feel it is the key to keeping perspective. To paraphrase the fabled French inspector Jacques Clouseau: Nothing matters but the facts! Without them investing is nothing more than a guessing game!

The Fed, as expected, raised the target federal funds rate to 1.75-2.00% in June and the markets yawned. The Fed was quite transparent about the hike, so this is a normal market response. Surprisingly, the markets actually reacted more negatively to the Italian elections but have since reversed course. In fact, rolling one-year volatility for the bond market reached an all-time low this quarter.

The key question is: When do rising rates and a flatter yield curve matter both for the bond market and the economy? As we discussed last quarter, we feel short-term rates are still well below the level at which economic growth would be stunted. Looking at the fed funds rate alone is not very helpful; one should also look at the neutral rate as well as the shape and level of the yield curve. As the curve has flattened, investors have become worried that it may signal an impending recession given that a flat yield curve preceded the past two recessions. But according to a recent piece by UBS economists, there are two reasons this may not be the case today. First, when we’ve had flat curves in the past, they were typically accompanied by restrictive monetary policy (i.e., the fed funds rate was above the neutral rate – the theoretical interest rate that neither accelerates nor slows Gross Domestic Product (GDP) growth – thereby sucking credit from the system.) Second, flat to declining long-term rates have historically occurred when the Fed is attempting to reverse the effects of a recession, not during the midst of a tightening cycle.

Additionally, as highlighted by Evercore ISI research, past recessions have usually followed a peak in rates when the fed funds rate approached the nominal GDP growth rate, but we are meaningfully below that today. The twelve-month average fed funds rate is 1.4% compared to nominal GDP growth rate of 3.9%. The last time we had such a gap during a rate normalization by the Fed was 2005, which was still three years before the next recession. This dovetails nicely with the Fed’s view that the risk of an imminent slowdown is low and that rates will likely peak in 2020, when the median expectation is for a fed funds rate of 3.5% versus nominal GDP of 3.9-4.2%. These levels are more in-line with restrictive monetary conditions, despite being lower than past peaks. Of course, given the accuracy of past Fed projections, we continue to view these as guesstimates.