By John Toohey, CFA
VP, Head of Equities
There’s a well-worn saying relating to the prominent position of the United States in financial markets: “When America sneezes, the rest of the world catches a cold.” The rest of the world is already showing some symptoms, so the question to ask is whether the U.S. can stay healthy if those overseas economies are actually coming down with the flu.
Among the first who need to consider that question are the policymakers at the Federal Reserve, who will almost certainly continue their monetary tightening when they meet this week. A 0.25% interest rate increase would be the eighth in the Fed’s current tightening cycle, and the market is laying heavy odds on a ninth rate bump in December. At this point, at least two more hikes are also envisioned for 2019.
The Fed is following a standard approach with its tightening. The thinking is to move rates higher when the U.S. economy is strong to try to limit inflationary pressures now and to give it some room to stimulate via rate cuts if the economy slows later. It’s as much art as science, and getting it right is no mean feat.
The U.S. economy is humming along, with second-quarter GDP topping 4% on an annualized basis and the past 12 months nearing 3% – a level not seen in more than a decade. Key indicators are buoyant, with the country at or near full employment, industrial output beating forecasts, and consumer confidence at its highest since late 2000. Stocks are at record highs amid double-digit earnings growth. Going by the book, given those conditions, the Fed shouldn’t hesitate to jack up short-term rates twice more before the end of 2018.
Many of those arguing for Fed caution on rates point to its potential impact on the Treasury yield curve, which has flattened significantly in the past year.
The closely watched yield spread between 10-year Treasuries and 2-year Treasuries narrowed to a mere 21 basis points (0.21%) last week – at the same time in 2017, that spread was 83 bp. The Fed’s three rate hikes and expectations of a fourth next week have contributed to rising yields among short-maturity Treasuries. A flattening yield curve often precedes an inverted curve (2-year yields higher than 10-year yields), which has historically presaged a recession within the next 12-18 months.
Flattening at the long end of the curve typically suggests growing concern about the economy, as investors rotate from riskier assets like stocks to U.S. government bonds perceived to be safer. But the Standard & Poor’s 500 set a new record last week, so it seems investors aren’t yet bailing on stocks. Meanwhile, much of the demand for longer-dated Treasuries (which push down their yield) is coming from income-starved investors from overseas, where yields are far lower.
This observation doesn’t brush off the possible negative consequences of a flat or inverted yield curve. Banks, for instance, tend to “borrow short and lend long” – that is, they pay their depositors based on short-term Treasury rates and loan out money based on longer-term rates. A flat yield curve cuts into their net interest margin and thus can affect their willingness to lend.
Along with rate increases and the Fed’s escalating schedule for paring back its $4 trillion balance sheet, less bank lending is another form of monetary tightening that could end up strengthening the U.S. dollar and slowing the economy. A mightier dollar could amplify the softening conditions already being seen in large economies like Europe and China, as well as in other emerging markets, as tariffs and other trade impediments grow in scale and energy costs climb.
A slowdown overseas could feed back into the U.S. via an ebbing economy and declining stock prices that leads to a pullback in consumer spending, which could produce a downward spiral that further hurts the economy, share prices and consumer confidence and ultimately lead to recession.
It is this risk of overseas contagion spreading to the U.S. that should be on the Fed’s mind as it charts its interest-rate course for the rest of this year and in 2019.
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