The Ghost of Paradigm Past
In 1989 the United States bond market made up about 60% of the world tradeable bond market, by the end of 2018 that number was lower than 40%, as shown in Chart 1 below. And whereas then an inverted yield curve was believed to signal a looming recession as in past economic cycles, today it possibly signals the lack of sufficient supply of U.S. bonds for global portfolios given yield differentials, as well as Fed policy. While disconcerting and disruptive to the way investors have historically viewed the U.S. yield curve, the reality appears fairly benign to us. The United States is in “relatively” better economic shape than many other developed countries. While Federal Reserve Chairman Jerome Powell was raising the federal funds rates in 2016, Mario Draghi, his counterpart in Europe, was lowering rates at that time and continues in a highly accommodative mode.
So long as there is global fixed income demand, rationale buyers will consider all available options, taking into account both yields and currency risk. As shown in the chart below courtesy of J.P. Morgan, U.S. Aggregate benchmark rates at 2.49% are far superior to Germany’s Aggregate rate of 0.12% and Japan’s 0.0%.
On July 10th, Chairman Powell gave testimony before the Committee on Financial Services, U.S. House of Representatives. He commented on the increasing inclusion of such factors as trade tensions and global growth, in addition to monitoring price stability and employment, in considering Fed policy. At the end of September, the Federal Reserve intends to end normalization of its approximate $3.9 trillion balance sheet with the aim of holding primarily Treasury securities in the longer run. The Federal Open Market Committee meets later this month on July 30-31. It is widely expected the Federal Reserve will cut the 2.25% to 2.5% target fed funds rate. Lower short-term rates would not only quell economic outlook concerns, but also tend to normalize the shape of the yield curve.