Quarterly review: Worries rise over pickup in inflation, softening economic momentum, global protectionism
Despite a generally positive economic backdrop, markets gyrated wildly as volatility returned in the first quarter, spurred by fears of runaway inflation, rising interest rates and political unrest in Washington. Unease rose over a possible U.S.-China trade war.
The U.S. Congress approved a substantially stimulative federal budget. Two- and five-year Treasury yields rose and three-month LIBOR soared in Q1. The fed funds rate rose 25 basis points. Investment grade credit spreads widened.
First quarter U.S. economic growth remained solid, though momentum moderated. A majority of companies beat fourth quarter revenue and earnings estimates.
A Brexit transition deal was reached in the UK; combined with improving wage growth and low unemployment, the BoE will likely have the confidence to raise rates, though we expect at a glacial pace.
Markets gyrated wildly as volatility returned in the first quarter. Despite a generally positive economic backdrop, global equities sold off sharply on fears of runaway inflation, rising interest rates and continued political unrest in Washington. As the quarter progressed, growing unease about a trade war came into focus as the U.S. said and it would impose import tariffs on steel and aluminum and then many other products, causing China to announce retaliatory tariffs on 106 U.S. exports including soybeans, autos and chemical products.
In Washington, Congress approved a federal budget incorporating substantial fiscal stimulus, adding $300 billion to the deficit over the next two years (in addition to $1.5 trillion over 10 years from tax reform). Higher government debt issuance to fund tax cuts and spending increases, combined with the unwinding of the Federal Reserve (Fed) balance sheet, is expected to exert upward pressure on rates. The fed funds rate rose 25 basis points (bps), to 1.50%–1.75%. While the dot-plot was unchanged (a median of three hikes in 2018), Fed expectations rose to three rates hikes in 2019 and two in 2020, and several committee members raised their forecasts from three to four hikes this year. The revisions reflect higher growth expectations for 2018 and 2019, given the impact of fiscal stimulus and a lower unemployment rate through 2020. Core inflation was revised higher in 2019 to 2.1%.
Firming U.S. inflation, strong growth, U.S. fiscal expansion and a less accommodative policy stance from central banks caused yields to steadily rise. Two-year Treasury yields ended Q1 38bps higher, at 2.27%, and five-year yields rose 35 bps to 2.56%. Three-month LIBOR soared 62bps to 2.31% over the quarter, due to a variety of factors including increased Treasury issuance, rate hike expectations and excess demand for U.S. dollar funding.