Forget the Fed Sweepstakes. Watch Treasuries Instead.
With President Donald Trump expected to announce his pick to lead the Federal Reserve, the focus has been on Chair Janet Yellen being renominated or, alternately, Gary Cohn, Jerome Powell, Kevin Warsh or John Taylor succeeding her.
Here is an out-of-consensus view: Instead of making their decisions contingent on whether a "hawk" or a "dove" will run the Fed for the next four years, investors should take their cue from the Treasury bond market.
If this were 2010, when Ben Bernanke was named to a second term by President Barack Obama, or even 2014, when Yellen was named, knowing the identity of the next Fed chair would be of great significance. After all, the recovery from the recession was still in its early stages in 2010 and 2014, and an easier or restrictive policy would have prolonged, or stemmed, the surge in equity prices. That is no longer the case.
The U.S. business cycle, in the ninth year of recovery, is at a late stage by historical standards. And the powerful signal from the narrowing of the spread between two-year and 10-year Treasury securities suggests a growth slowdown with the potential for recession. Consequently, the next Fed chair may well end up being a follower rather than leader of credit and equity markets. That means investors shouldn't fall for the distraction of the parade of Fed candidates visiting the White House.
Why? Let us assume that one of the two candidates investors consider a “dove,” Yellen or Powell, is named to the position. Suppose, as well, that Yellen’s Fed raises the federal funds rate once more on Dec. 13, and she or her successor increases three more times in 2018. These moves have been widely telegraphed to the markets.
Both the first rate increase by the Fed since the financial crisis in December 2015, and the second one in December 2016, were followed by a sharp narrowing of the spread in yield of two-year and 10-year notes. This also happened after the hikes in March and June this year, taking the spread to a post-2008 low of 74.9 basis points on Oct. 17. This compares with a recent high of 136 basis points on Dec. 22.
With inflation still at low levels, even if rates increase fewer than four times between now and the end of 2018, that will likely push the two-to-10 spread lower and ultimately below zero. A negative spread was the leading indicator of the two most recent recessions -- in 2001 and 2007–2009 -- about a year after it crossed that threshold. Because the current recovery is long in the tooth, having begun in July 2009, the risk of rate hikes leading to a recession is especially high.
If rates are raised steadily over the next 14 months that would be a powerful signal for investors that a recession may be around the corner - - no matter who the next Fed chair is. Increasing risk of recession would call for a reallocation of investor portfolio from equities to bonds.
Now, suppose the next Fed chair turns out to be a “hawk.” Markets would place former Fed Governor Warsh, and Stanford University Professor Taylor in this group. Even Taylor, author of the “Taylor Rule” that would call for a much higher federal funds rate, has said in a recent research paper that policy rules “should not be viewed as ways to tie central bankers’ hands.”
Still, if Warsh or Taylor at the helm means rates rise faster next year than with Yellen or Powell, narrowing of the two-10 spread in the Treasury market, and signs of a recession, are likely to occur faster. The correction in equities, and the rush to a haven in Treasuries, would also be accelerated.
Warning to investors: Only a reversal of Fed policy, and a postponement of rate hikes, is likely to keep the speculative frenzy in financial markets going well into 2018. The two-year Treasury yield would then drop from its recent highs, widening the gap with 10-year securities. And no Fed candidate is signaling such a move.
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