Global bonds continue their rise as the Fed pauses

Given that 2018 ended with the suspicion that decelerating global growth and falling inflation/inflation expectations would force the Fed to pause, bond markets all over the world had begun to rally along with risk assets.  Seeing how his rebound has unfolded in Q1, the strength and broad-based nature of the uptrend in credit and risk suggest that the global economy may have averting the potential disaster scenario that was being priced in by markets in Q4 2018.  In this light, 2018-2019 so far has more in common with 2015-2016 and 2011-2013 when compared to the prior two pre-recession periods leading up to the cyclical turns in 2000/2002 and 2007/2008.  With that said, current market conditions still requires that market participants remain flexible even if a bias toward optimism continues to be favorable.  All it would take is for the 2018 lows in credit and risk to give way for major trends and sentiment to shift meaningfully.

Before discussing the rally in global bonds, a quick recap in FX & equities is in order.

• UUP, a bullish USD ETF, remains in an uptrend powered by a EUR/USD that has failed to move higher despite a favorable decline in interest rate differentials as a result of a less hawkish Fed.
• In contrast to the Euro, the 2018 weakness in the Chinese Yuan has reversed off the 7 USD/CNH level much like it did following the 2016 global growth scare.  Until this divergence in behavior between CNH and EUR is resolved, the FX space is likely to remain a bit ambiguous for the time being.  Therefore, the dollar's ongoing uptrend should be respected as long as UUP remains above the red-line support level.
• With dollar strength still weighting on emerging markets, it's unsurprising to see that EEM remains in the process of carving out a potential bottom.  A break above overhead resistance that also coincides with dollar depreciation would signal that the intermediate term trend in emerging markets has changed in a bullish manner.  That is obviously to be determined and a failure below the 2018 low for EEM can't be ruled out just yet. 
• Although dollar strength has been a headwind for US equities, it is not to the same degree as witnessed in EM.  While the latter has sold off persistently since the dollar began to trend higher at the beginning of 2018, US equities have instead moved sideways albeit in a volatile range.  Despite the sharp decline in Q4 2018, the long term trend (across multiple years) is still intact as long as price is above the 2018 bottom.  Even after factoring in the big advance in 2019, the DJIA has only increased by roughly 8% over the last 50 weeks which speaks to the wide range it has been in.  At the moment, the DJIA is testing the October 2018 high where failure here could provoke a correction within the trading range highlighted above.  

Bond markets all over the risk spectrum have risen with credit spreads tightening.

• As the 10-year treasury yield was making fresh 3-month (orange arrow) and 6-month (red arrow) lows in December, global bond markets started their respective rebounds.  From the safety of IEF, a treasury bond fund ETF, to TIPS, investment grade, munis, all the way to the other side of the risk spectrum, high yield and emerging market bond funds, the rally has clearly not lacked in participation.
• Importantly this provides market participants context when thinking about the sharp decline in long-term treasury yields.  Had this been occurring alongside a sell-off in riskier bonds, then a much more precautionary stance would be warranted.  It goes without saying that this is a very different credit environment relative to 2018 where the Fed was not expected to deviate from their tightening path.

• Another way to visualize this is through the simultaneous narrowing in domestic and international credit spreads that started at the turn of the year.  If market participants were truly fearful that falling treasury yields and a more guarded Fed were symptomatic of a dire global economic picture that was expected to persist beyond the first half of 2019, it's unlikely that credit spreads would've decline as they have.  
• Were credit spreads to widen again especially beyond the point they did last year with treasury yields continuing to decline, markets would then be sending a clear warning.  That is simply not happening as of yet.

The front-end of the yield curve has inverted but the long-end has not.

• As of the end of March, the yield curve spread at various points are as follows:
• 3-month vs FFR, -.08
• 2-year vs FFR, -.16
• 2-year vs 3 month,-.08
• 5-year vs 2-year, -.04
• 10-year vs 3-month, .01
• 10-year vs 2-year, .14
• 30-year vs 5-year, .58
• 30-year vs 10-year, .40
• Although the yield curve has historically inverted prior to recessions, a front-end inversion typically has a much longer lead time (see this excellent video for more on this) and does not necessarily suggest that long-term trends in risk assets are at risk of reversing soon.  Moreover, the long-end has yet to do so and this too has typically happened in the run up to a cyclical downturn.  
• Rather than focus on lead times between past inversions to recessions to determine how close we are to the end of this cycle, our proximity to a cyclical turn can be better understood when the signals from the yield curve are taken into consideration with other market and macro factors.  To put simply, a yield curve inversion will begin to matter when credit spreads start to widen while equities and treasury yields trend lower for months on end.  
• Also it must be pointed out that the inversion itself isn't as useful a timing tool as advertised.  A recession is likely upon us as soon as yield spreads first start to steepen following an inversion with the Fed aggressively cutting short-term policy rates faster than long-term yields can decline. 

• To improve timing even further, one should not ignore the "economic" inversion signals that also have a tendency to occur prior to recessions.  In this case, when the pace of nominal GDP growth slows to less than the 3-month treasury rate, this is a sign that monetary policy has become too tight.  When this story is being corroborated by the spread between the pace of growth in retail sales and the 3-month rate, investors would do well by heeding such warnings.
• As of last month, the retail sales growth/3-month spread is waving a red flag and it will be interesting to see whether the NGDP growth/3-month spread follows when the latest figures arrive.  The other possibility is that the weakness in retail sales will prove to be only temporary particularly in light of the latest recovery in risk asset.  

• Finally, the Q4 2018 reading for the above expansion/recession gauge created by Ed Lambert using components of economic capacity (introduced in the January post from earlier this year) was nowhere near potential recession territory (below orange line) never mind in recession (below red line).  "As spare capacity starts to rise after hitting the effective demand limit, the economy rides the edge of recession."  Today the economy may be using less of the spare capacity available, but not to the point where we are likely to tip into recession.  In other words, a deceleration in economic activity that has only just begun and may not be long lasting is not a guarantee that outright contraction is a certain outcome in the months or years ahead.

Key Takeaways:

Where an acceleration of US economic growth in 2018 incentivized the Fed to resume their plans to tighten monetary conditions which came at the expense of the global bond and risk asset markets, 2019 has ushered in a more patient approach from the Fed.  Unsurprisingly, credit and risk assets have rebounded on the back of this shift in the expected monetary path.  This forceful move higher particularly across the risk spectrum in the bond market also seems to indicate that investors believe that this pause from the Fed should be enough to see the economy avoid recession.  

Yes the front-end of the yield curve has inverted and this isn't something to be ignored.  However had bond investors been positioning for an immediate downturn, it is unlikely that riskier bonds would have seen such a resurgence.  Therefore, the signals from the yield curve will begin to matter when bond investors start to discriminate against riskier bonds in favor of safe haven treasuries.  In such a scenario, credit spreads would be widening which again has not been the case as of today.

In terms of whether the Fed's change in attitude is warranted, it's important to point out that inflation has averaged about 1.6% since the Fed explicitly set their 2% inflation target in 2012.  This fact gives them ample room and political cover to react whenever financial conditions tighten excessively enough to potentially harm the real economy as witnessed in 2011/12, 2015/16, and again in 2018.  This in turn has acted to prolong the expansion.  Had the Fed decided not to respond to such periods of financial market turmoil as they have by communicating a more accommodative stance and instead opted to continue tightening despite persistently below target inflation, they would be putting their policy credibility and even their political independence at risk.  Either the Fed allows nominal GDP to grow at a rate that is consistent with their chosen symmetric inflation target or they must explain why they have been treating 2% essentially as a ceiling.  Citing "transitory" factors for why they have undershot this part of their mandate is simply not credible seeing as this miss has been going on for too long.

As the best Fed watcher, Tim Duy, puts it:

The Fed hasn't delivered on inflation as Powell admitted last week, which by itself is a problem.  That problem would be compounded by delivering a recession in an effort to fight a nonexistent inflation problem.  You want to stay independent, you have to do your job.

Thus where past cycles have ended because the Fed was unwilling to offset decelerating growth in nominal GDP due to inflationary pressures and/or a spike in the price of oil, at present neither should inhibit the Fed from easing preemptively should financial and economic conditions require.  As mentioned, they have failed to hit their inflation target on average since instituting it so this cannot be grounds to be overly restrictive anytime soon.  Moreover, since topping in 2018 oil remains mired in a secular bear market that has featured multiple vicious declines that has left its price over 50% below its all-time high.  To add to this, much like Japan exported disinflation via weak aggregate demand after their 1980s bubble burst, Europe's stagnation still very much lingers with the same effect.  Considering all this, the Fed's dovish pivot is easy to justify.

To close, the powerful rebound in bonds and risk assets since the Fed began telegraphing their change in stance gives the impression that the recession warnings from 2018 were far too early.  The economy may be decelerating but is not likely to enter a downturn this year.  The Fed has acted, and just as crucially they have ample room and political cover to be more aggressive should the economic data deteriorate alongside financial market conditions.  With that said, seeing as the dollar is still in an uptrend while US equities are nearing resistance at the top of their multiyear range, investors should still remain open to an array of possible outcomes.  We aren't out of the woods just yet even if it's becoming easier to envision a bullish resolution.