The Fed has lowered its growth outlook for the US Economy, and in March signalled an expectation they will likely not raise rates again this year. Bond markets in the US are pricing in rate cuts this year, as fears of weakening global growth, notably that of China and Germany, rise quickly and concerns about recession grow. In Europe, those same worries have pushed out expectations for a late 2019 rate hike, and speculation is growing at what stimulus the European Central Bank (ECB) could provide, if needed.
Normally, rising recession fears that are reflected in falling bond yields also lead to falls in equity prices. Yet equity markets remain resilient in the face of growing concerns regarding the world’s largest economies, US investment grade credit spreads are at YTD tights, and European credit spreads are also at YTD tights. In the government bond markets, in the US recently we have seen the fall in yields start to switch from the intermediate part of the curve more to the front end of the curve, while in Europe yields in the long end are falling most quickly. How to square all these divergences?
US benchmark 10yr yields vs. S&P500
We believe that these market moves are all logical and consistent with one another if viewed at through the lens of global financial markets increasingly expecting the Fed and ECB to provide additional monetary stimulus, and do so sooner rather than later.
In the US bond market, the Fed has the ability to first use traditional cuts to its benchmark policy rate in order to provide stimulus, so as expectations of that rise, short term yields should fall faster than long term yields. While the curve has flattened to this point, there have been signs bond market leadership is starting to shift to the front end, and expectations of near term rate cuts are rising.
In Europe, policy rates are currently at -0.4%, where they have been since March of 2016. With an inability to do anything more than tinker with its policy rate, we believe markets are expecting any further stimulus from the ECB to have the result of pushing long term interest rates lower, given short term rates are also negative.
As a base case, we do not expect a recession in either the US or in Europe in 2019. However, despite apparent divergences between falling bond yields on recession concerns and still healthy risk-asset performance, when viewed through this lens, the relatively strong performance of riskier assets is logical as markets are increasingly expecting these central banks to come to the rescue, and sooner rather than later.