Risk On
Fed Chairman Powell gave the green light for risk on – and risk markets have wasted no time responding. Not only did he say rates are near the neutral rate, he explained stocks are reasonably valued, and the banking system is strong – we believe this is about as strong a buy signal as a Fed chair will ever give.
Powell’s comments also make clear that the Fed’s Board of Governors are made up of critically thinking policy makers, and they will not slavishly follow their dot plots upward – as many market participants had expected. Though Powell used the diplomatic language of a Fed Chair, he outlined the complex nuances of Fed policy making. Though many market participants have been playing this game, when Powell’s Fed draws dots, they do not inevitably connect them with their policy pencil. The Fed’s independent board of governors will be data dependent and are expected to proceed with caution.
Stocks are up, and the market response from other sectors are confirming this risk-on move.
1 – The Treasury Inflation Protected Securities (TIPS) market is responding to Powell’s comments with a meaningful rise in inflation expectations back towards 2% (See chart 1).
2 – The “Belly” of the Treasury curve is outperforming shorter and longer maturities, or the wings of the yield curve. Intermediate treasuries are especially sensitive to future expectations of Fed policy and the drop in yields yesterday on 3-10 year maturities shows bond investor confidence that the Fed will slow down its pace of rate hikes (See Chart 2). The belly of the curve looks attractive if you believe the bond market had discounted too much tightening.
3 – The Treasury yield curve (2s-30s), has steepened meaningfully (See chart 3). Investors are likely to discount high growth and higher inflation, as well as a Fed slower to raise rates. Credit is usually under pressure when the curve flattens. If you believe this is just the beginning of a steeper curve, it could be a good opportunity to buy credit strategies, especially those that have underperformed recently due to spread widening.
4 – And the dollar? Since Powell spoke, it has been dropping in value (See Chart 4). This is a very powerful risk-on signal for Emerging Markets. EM had been under pressure as the dollar threatened to break out of its trading range in recent weeks. Emerging Market FX is making a sharp upward move, and it seems likely Asia EM will follow through as well.
Will this last? Like the Fed, let’s be data dependent – earnings and growth have been good so far (with pockets of weakness), so this risk-on move likely can be sustained. Risks on the horizon? Think G20 Summit and more rhetoric about Tariffs.
10 YEAR TREASURY
TREASURY CURVE
2/30 TREASURY SLOPE
US DOLLAR INDEX
CURRENCY RETURNS
Source: Bloomberg, accessed on November 28, 2018
– Jonathan E. Lewis, Chief Investment Officer
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