Seeking Alpha

Can The FOMC Steepen The Yield Curve Without Initiating A Recession?

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Includes: FLAT, GS, STPP, TBT, TLT, UUP
by: M&T Research Group
Summary

There is consensus that the FOMC will raise rates three to four times over 2018.

Historically, rate increases occur with the increase of inflation and is followed by recession.

Will fiscal stimulus along with monetary policy tightening be enough to stave off recession?

Over the course of the year the FOMC has consistently raised rates every time they said that they would. These hikes were not huge, but each round was met with serious doubts by investors and traders. Just before Thanksgiving Goldman Sachs (GS) announced that they saw the FOMC increasing rates four times again next year. Bloomberg conducted a survey on 41 economists, they came to the conclusion that the FOMC would hike rates three times over 2018. Again, many traders that I interact with on a regular basis have serious doubts about this actually taking place. I see the doubt in the FOMC stemming from the fact that they promised rate raises for years and never consistently delivered until this year. The flattening yield curve also gives doubts that the economy will continue to do well in the long run.

Near the end of 2016, just after Trump was elected president, yields were bid and the curve steepened. This was mainly due to the fact that traders were pricing in Trump fiscal stimulus and the start of normalization by the FOMC. This was, or is the right trade, it was just a bit early. Thus far, the FOMC has held up their end of the bargain. Increasing rates, then proposing and enacting policies to start normalizing the balance sheet. Trump, on the other hand has not followed through fast enough, and investors lost patience and switched attention to the European economy and hopes that rate hikes may be mentioned at an ECB meeting.

With the Presidency so deeply refuted by many, getting anything done in congress will likely take an act of God. Traders and investors expecting fiscal stimulus right off the bat from President Trump were let down and these economic bonuses were priced out of bonds, yields and the US dollar quickly over the course of 2017.

As we entered the spring of 2017, the European economy started to come to the forefront, as economic data became better. There were many rumors that the ECB would be dropping hints that rate hikes were to come soon and that QE would be completely stopped. This pushed the Euro up about 12% in four months. This is a huge change for the currency to undergo in such a short amount of time. Keep in mind that this occurred because investors lost hope in Trump’s fiscal stimulus, got bored with the slow and steady FOMC and held high hopes that the ECB would announce rate hikes. Because these moves were so strong, they have become the staple trades of 2017 for many firms. This is the main reason that the Euro has held up so well recently, even in the face of political uncertainty in Germany, Italy and BREXIT. For example, when Merkle announced that she was unable to form a coalition government mid-November, the Euro dropped slightly and then rebounded even higher in the following days.

Going into the Euro trade a bit more in depth, managed assets are, at this moment longer Euro futures then they had been in September at the highs, see table below. In addition, we have dealers building large short positions waiting for the transfer or funds back into US yields and the dollar for 2018; see the chart below. This type of positioning is extreme, we would expect a reversion to the mean to occur at some point, looking at this data alone.

Table created by myself with data from the CFTC.

Chart created by myself with data from the CFTC.

All of these factors play into the continued flattening of US yield curves and the decrease in USD value since late 2016. Came across this from CNBC Dec 2016, where representatives form Bank of America and BMO Private Bank both talk about the US trade getting ahead of itself and a possible shift into the international arena. Traditionally, flat yield curves are an indicator of future recession, but in this case, flattening has been led by the transition of high hopes from the US to other countries. The idea internationally being to look for taper tantrum opportunities elsewhere. That is more or less exactly what we got with the Euro Dollar this year. In addition, the FOMC would be silly to not look back at history and see the pattern of yield curve steepening. Just as longer dated bond traders start to trade like the danger of recession has passed, a recession comes. This is the reason why I believe the FOMC has held to its tightening path over the year regardless of what the inflation numbers have indicated. Going back over the charts it is pretty clear that a lagging response to increasing inflation is immediately followed by recession; as shown in the charts below.

Chart from tradingeconomics.com

Chart from FRED economic data.

Overall, the FOMC has been successful at their mandate this year. To start normalization with little to no affect on the stock market and the economy. Economic numbers have been looking better, then in the past and the markets have continued up. The main concern for investors of late are the low inflation numbers that have been coming in. Most are expecting some kind of tax reform package to pass before 2018, this has mostly been reflected in US equities and also Chinese equities. The reason we have seen the Chinese economy react is the tax package touts a corporate tax rate that is 5% lower than China’s current rate. This is why Chinese stock have been faltering lately, and the main reason steel and copper futures have been down a bit.

To make this puzzle a bit trickier for investors, when copper and chinese equities are down that usually signals the same for US markets. But, since the moves are the result of fiscal policy change in the US I do not think this correlation holds in this case. If you clicked on the first link you will have read that the longer dated treasuries are no longer pricing in fiscal stimulus. Should the anticipated tax reform pass, this should bring up the longer dated yields and the curve overall.

US annual growth rates have been coming up since last year, this is the same, more or less for US inflation rates, see charts below.

Both charts from tradingeconomics.com.

Short term rates are largely driven by FOMC rate decisions, where longer term rates are driven by inflation. The fiscal policy measures into both, depending how the timing is to be worked out. I think that the short US yields trade is about to be over as the FOMC takes it upon themselves to steepen the curve by continuing its normalization mandate. This will be supported by increased inflation through the fiscal stimulus coming out of congress.

In conclusion, the balance lies on the tax bill passing with reforms that will incentivize corporations to remain in and return to the US. Either way, trades are setting up to be long US yields for 2018. To do this you could get long the following ETFs; STPP, UUP and TBT. On the short side, TLT and FLAT would work as well. I will personally be trading the 10 and 30-year bond futures to the short side, as well as the US dollar in the futures and spot FOREX markets as we enter 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have been holding long USD in the spot FOREX market over the last two weeks.