The Daily Prophet: Fed Breathes Life Into Bond Market's Rally

Connecting the dots in global markets.

The Federal Reserve raised interest rates on Wednesday for the third time this year and significantly boosted its forecast for economic growth. That would normally be a recipe for disaster in the bond market, but fixed-income investors walked away smiling.

Treasuries -- the benchmark for corporate and consumer borrowing costs --- rallied as yields declined from the high end of their recent range. Even though the Fed raised its benchmark rate by a quarter percentage point to a target range of 1.25 percent to 1.5 percent and lifted its estimate for economic growth next year to 2.5 percent from 2.1 percent, it still doesn't see inflation accelerating. That's key because faster inflation erodes the purchasing power of fixed-interest payments over time, eroding the value of bonds. The breakeven rate on five-year U.S. government notes, or what traders expect the rate of inflation to be over the life of the securities, fell almost half a percentage point to 1.78 percent, the biggest drop in two months.

While bond investors celebrated, dollar traders looked like they were broadsided. The Bloomberg Dollar Spot Index hits its lows of the day after the decision, falling the most in three weeks. The index had risen in each of the last seven days, it's longest rally since the start of 2016, on speculation the economy was doing so well that the Fed just might flag that it planned to raise rates four times next year. Alas, the central bank stuck to its outlook for three increases. The losses Wednesday add to a terrible year for the greenback, with the Bloomberg Dollar Spot Index down 7.82 percent. The dollar could lose more ground as the prospect of strong economic growth and tighter monetary policy outside the U.S. more than offsets higher rates at home, according to Bloomberg News' Lananh Nguyen. The economic growth “we’re seeing in Europe, emerging markets and the rest of the world will likely cause the dollar to sell off again,” Erin Browne, the head of asset allocation at UBS Asset Management, which oversees about $770 billion, told Bloomberg News.

The upside to a weaker dollar is that it makes U.S. companies more competitive abroad. Perhaps that's one reason why the S&P 500 Index immediately jumped on the Fed announcement, before  giving up those gains in a late-session selloff that snapped a four-day rally. Not even reports that House and Senate Republicans reached an agreement on tax reform that includes a big rate cut for corporations could keep stocks in the black. The strategists at Bloomberg Intelligence note that if the new tax policy is effective, Fed doves could quickly morph into hawks. That could boost Treasury yields and raise borrowing costs for companies. There's little margin for error. The S&P 500's forward price-to-earnings ratio has increased 7.5 percent this year to 18.3 times, and is up 12 percent from the 16.3 times level in early November 2016, according to the BI strategists. Of the 25 percent gain in the S&P 500 since just before the 2016 election, half was due to earnings growth and half from multiple expansion.

Oil traders largely ignored the Fed, choosing instead to focuso on an OPEC predicted that the global market for crude won’t rebalance until late next year after boosting forecasts for supplies from the U.S. and other rivals. The Organization of Petroleum Exporting Countries’ monthly report raised its outlook for non-OPEC supply in 2018 by 300,000 a barrels a day, as its projections for American output caught up with those of the U.S. government. As a result, an initiative by OPEC and Russia to clear a global oil glut by cutting output -- previously seen succeeding in the third quarter of 2018 -- will take effect more slowly, according to Bloomberg News' Grant Smith. American shale explorers, who grew more efficient during the industry’s three-year downturn, are locking in future revenues as U.S. prices near $60 a barrel, potentially readying for a new surge in drilling. OPEC increased estimates of its competitors’ output in 2018 for the first time since the forecast was introduced last summer. It expects rival supplies will increase by about 1 million barrels a day, or about 1.7 percent, in 2018.

The precious metal, heading for its worst quarter in a year, rose the most in more than three weeks in a somewhat unusual move. While gold prices have slumped amid bets that higher rates will hurt demand for non-interest-bearing assets, they have rallied in the months after recent Fed rate hikes, according to Bloomberg News' Susanne Barton and Eddie van der Walt. Once the Fed “is out of the way, we expect people to start talking about the everything-bubble again, and about the implication for havens when it bursts,” Mark O’Byrne, a director at bullion dealer GoldCore Ltd., told Bloomberg News. Money managers tripled their short positions in gold last week, the fastest such move since record-keeping started in 2006, U.S. government data showed. The jump in bearish bets came as prospects for higher rates and progress on tax legislation deepened a slump for bullion prices. Short positions had fallen to a five-year low the previous week as North Korea-U.S. tensions and uncertainty over the Senate tax bill fueled demand for the metal as a haven.

In many ways, the Fed's decision was a prelude to what's to come Thursday in what is being billed as a central bank bonanza. The European Central Bank, Bank of England, Swiss National Bank and Norges Bank are all scheduled to make policy announcements. Although none is expected to raise rates like the Fed, they will still be closely watched for what they say about 2018. The synchronized global economic recovery has Wall Street economists are telling investors to brace for the biggest tightening of monetary policy in more than a decade next year. Citigroup and JPMorgan predict average interest rates across advanced economies will climb to at least 1 percent next year, according to Bloomberg News' David Goodman. Bloomberg Economics predicts net asset purchases by the main central banks will fall to a monthly $18 billion at the end of 2018, from $126 billion in September, and turn negative during the first half of 2019.

If you’d like to get The Daily Prophet in e-mail form, right in your inbox, please subscribe to this link. Thanks!

Bond Markets Really Are Signalling Slowdown: Achuthan, Banerji

Bitcoin and European Bonds Have a Lot in Common: Mark Grant

Productivity Is Improving If You Know Where to Look: Neil Dutta

Behind What Central Banks Will Do This Week: Mohamed A. El-Erian

Bought Apple Stock in 1980? Held It? Don't Brag: Joe Nocera

    Before it's here, it's on the Bloomberg Terminal.