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Ok – this is a leftover from last year that didn’t work. Frankly, I think we were right and the market was wrong?! I suppose the curve did what it was supposed to do…..as the Fed raised rates for a third year, yields in the front end moved higher than yields in the back end. Our view had been that the transition from Quantitative Ease (QE) to Quantitative Tightening (QT) would put significant upward pressure on the back end of the curve as the price insensitive buyers (central banks) became net price insensitive sellers. An overly flat curve now suggests that recession is looming. We disagree. We will know by the end of the first quarter whether this prediction works out. The Fed will be at its full $50B per month run off and the ECB will have fully ended QE. On top of that, the Treasury will be increasing net issuance by an annualized $1T to cover the fiscal stimulus. Let’s see who’s going to step in and buy long government bonds at these paltry real yield levels with those technicals hitting.
US High Yield returns 10%
Starting at a yield of ~8.0%, the average yield of the market needs to fall ~50 bps to 7.50% to generate that 10% return. It can do that a couple ways. If yields rise about 40 bps across the intermediate Treasury curve, then credit spreads need to narrow by 90 bps to 420 bps. This is wider than the average yield spread of the last few years. It would also follow the pattern of a similar cycle back in 2005. Or, if Treasury yields fall, credit spreads need to narrow by that much less than 50 bps. With strong corporate profitability, no sign of an impending recession and defaults expected to remain around 2%……no problem.
The 10 year US Treasury hits 4% or 2%
The truth is, the 10 year will probably spend most of 2019 trading around 3% while watching the data like the Fed. If the current growth slowdown does not end in a soft landing, then recession risks grow and 2% is a good resting spot for the 10 year.4%? It looked like a given during the first week of November when yields reached 3.25%. But the untimely death of equity market FOMO created a flight-to-quality bid that brought yields down toward 2.8%. Assuming the Fed can indicate a dovish bias into 2019, yields should head back above 3% as the flight-to-quality bid fades. A bit of inflation from full resource utilization (3.7% unemployment; 78.5% capacity utilization), a dose of QT and a sprinkling of $1T in additional Treasury issuance could well push yields to a new handle high for the cycle.
The US Dollar rises 10%
The dollar was supposed to fall in 2018 and it’s supposed to fall in 2019. The rest of the world should be expanding at above trend growth and the growth and interest rate divergences to the US should be narrowing. But, it’s just not happening that way. Maybe after a 10 year global expansion, its time to pause and consolidate. Further, the geopolitical situation may not settle down. US-China trade negotiations could escalate, Brexit might be messy and the administration might have its hand full with a split Congress. In that mix of scenarios, investors will want the safety of the USD.
Oils rises to $75
It wouldn’t take much. A meaningful agreement on productions cuts from the OPEC+ group with a little acceleration in the global economy should do it. If the PBOC also contributes with continued ease directed at an infrastructure spend, then $75 may even seem a little bit low.