The Federal Reserve raised the target range for the effective federal funds rates (EFF) again last week, now up to a range of 1.75% – 2.00%. They also raised the rate they pay banks interest on excess reserves (IOER) by 0.20%. With this bump, I wanted to see the print for the average bank prime loan rate over the weekend before commenting.
May’s print for the prime loan rate was (unexpectedly) unchanged at 4.75% and the average yield for Baa corporate bonds inched higher to 4.83%, bringing the “corporate curve” back to positive territory (you can read about that here). We’ve danced back and forth for the past 6 months so we’ll just call the curve flat on average. However, with the Fed’s hike last week, the prime loan rate bumped up to 5.00% over the weekend which inverts the curve again unless we see corporate yields rise in tandem this month. A flat curve is OK but if the gap widens to a larger inversion, that’s when we can expect a negative economic impact.
Yields on the long end (10+ years) have remained anchored here and are actually lower than the level they were trading at on last week’s Fed announcement. One week doesn’t make a trend but I’m not seeing long-term inflation or growth expectations push higher so I’m still expecting long yields to remain range-bound around these levels (probably a 40 basis point range). If that’s the case then corporate yields will not keep pace with additional hikes in short-term rates. This means, in my opinion, that we’re now at that critical point where each Fed rake hike moving forward will apply a good bit of pressure on the corporate sector and will slow economic growth.
The Fed is once again behind the curve and inflation is forcing their hand. Here are my thoughts on why I expect them to continue increasing short-term rates and why it should further invert the (corporate) yield curve.
- US dollar weakness last year led to a year-over-year increase in import prices and energy prices – both are key contributors to short-term swings in inflation. Plus, any trade tariffs will only increase import prices further. I still expect inflation readings to come in higher over the next few months which will likely keep the Fed on its rate increase path this year. However, I ultimately think this is a cyclical swing in inflation and the inflation rate should start to trend lower again in 2019. The bounce in the US dollar so far this year will start to slow year-over-year numbers in early 2019.
- Credit card and sub-prime auto delinquency rates are rising. On average, the consumer looks spent which is starting to create signs of stagflation. Again, why long yields haven’t been increasing.
- Chairman Powell was asked about the flattening yield curve (the Treasury curve) last week and gave the typical answer that they’re not concerned about it and don’t think it will invert. This tells me they expect to remain on the rate increase path because they don’t think they’re causing any problems.
- The eurodollar curve from Dec 2019 to Dec 2021 is already flat (literally 1 basis point as of this writing) and is pricing in another 5 hikes between now and end of 2019. I don’t think we get 5 between now and then.
I’m largely seeing conflicting signals right now though which leads me to believe most markets will be somewhat choppy and range-bound through the summer. Overall, nothing too serious affecting the US stock market yet (financial conditions are still extremely loose, leadership is definitely narrow but breadth isn’t falling apart too badly yet with strength in small caps) but I’m definitely seeing the early signs of slowing ahead. I’ll provide some updates on this through the summer.
Looking Ahead
With the amount of debt that has been accumulated around the world over the last decade (primarily denominated in US dollars), the world needs a weaker US dollar or else bad things will happen. We’re still seeing funding pressures and mini “short squeezes” throughout the world, namely in Emerging Market nations right now, but longer term the dollar has to weaken and that will boost returns for things like commodity prices and international based investments. I’ve been using the strength in the US dollar this year to increase exposure to both and will continue to increase exposure as long as the dollar rallies. I think we’ve hit the turning point where we start to build core long-term investments for the next decade of growth that will be led by Asia. I’ll expand on this and highlight a new investment position in my next post.
-Nick