07/03/2018
As the second quarter came to a close, the Federal Reserve could claim a victory, of sorts. It was finally able to achieve its target of 2 percent core inflation, for the first time in six years, with release of the Personal Consumption Expenditure (PCE) data for May. Being mindful of the threat of too much inflation, however, the Fed seems intent on additional future rate hikes, perhaps two more this year. Two weeks ago, Fed chair Powell said the case for continued gradual rate hikes is strong. Last week, Boston Fed president Rosengren said in a Wall Street Journal interview that he was comfortable with the “direction” of two more rate hikes this year, cautioning about the possibility of higher inflation from falling unemployment.

But just as inflation was edging higher in the second quarter, the yield curve was also flattening. The spread between the two and ten-year Treasury notes fell from 47 to 33 basis points, the flattest since 2007, setting off a debate about the curve’s predictive value. The flattening has mostly been dismissed as being due primarily to monetary policy distortions, especially global rate differentials, rather than foreshadowing an impending recession. But two regional Fed presidents last week warned that we should take notice. St. Louis president Bullard said that he saw, “The yield curve inversion as a key near-term risk” and urged the Fed not to be so aggressive. Atlanta’s Bostic warned of the risk of creating a self-fulfilling prophecy of investor risk aversion as the curve continues to flatten. And as the quarter came to a close, even the president’s own economic advisor joined the chorus of those urging the Fed to proceed slowly.

How Will Trade Impact the Success of Monetary Policy?

What ultimately proves to be the correct monetary policy will be impacted, in part, by what happens with trade, and that outcome is uncertain. July 6 is a day of reckoning of sorts, as the day that tariffs on Chinese exports are scheduled to take effect, with promised retaliation. Much as with the yield curve, investors had until recently largely discounted a truly negative impact from trade, but those fears have risen.

In the same Journal interview, the Fed’s Rosengren summed up the challenge faced by investors in trying to account for the impact of deteriorating trade relations, saying, “I did not expect that trade was going to be a meaningful macroeconomic effect. As time goes on, it’s less clear whether that assumption is accurate… the (economic) baseline is strong, but it’s reflecting data that doesn’t incorporate the potential for a significant disruption coming from international trade disputes…it’s a little bit hard to exactly predict because we don’t have very many experiences in the postwar data where we’ve had international trade disruptions…”

For now, market based indicators are suggesting the odds of there being either one or two more rate hikes this year are about even. For the quarter, the yield on the ten-year note rose ten basis points to 2.84 percent, but not before hitting a high of 3.11 percent on May 17, before trade risk began to rise sharply. The yield on the two-year note rose 25 basis points to 2.52 percent, as the Fed raised the overnight rate for the second time this year in June.

Emerging Markets Come Under Pressure as the Dollar Gains Strength

Another significant development in the quarter was the stronger dollar. The DXY dollar index rose 5 percent, after having fallen slightly more than 2 percent in the first quarter. Emerging markets have come under pressure as a result, prompting the central bank of India to urge the Fed to proceed slowly in order to avoid a dollar shortage. Many emerging market central banks have also raised rates themselves in an effort to defend their currencies, including India, Indonesia, Turkey, Brazil, Mexico and Argentina.

Contributing to worries over the availability of dollars has been the repatriation of U.S. corporate earnings that had been kept overseas and are now freed due to tax reform. In the quarter, the MSCI Emerging Market equity index fell almost 9 percent in dollar terms, roughly twice the size of the decline when measured in local currencies. The Bloomberg Barclays EM dollar based bond index1price fell 2.4 percent, while the local currency2 index fell 8 percent.

As long as economic growth in the U.S. remains solid, the Fed is likely to remain on its path of continuous gradual rate hikes. But if the economy slows, whether the result of rising trade tensions or something else, market expectations of two additional rate hikes this year may decline, and the voices warning us to pay attention to the flattening yield curve, dismissed today as modern Cassandras, will only grow louder.

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1The Bloomberg Barclays Emerging Markets Hard Currency Aggregate Index (dollar based bond index price) is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.
2The Bloomberg Barclays Emerging Markets Local Currency Government Index is a flagship index that measures the performance of local currency Emerging Markets (EM) debt. Classification as an EM is rules-based and reviewed annually using World Bank income group, International Monetary Fund (IMF) country classification and additional considerations such as market size and investability.
The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
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