Fed's 2019 Path May Produce Surprise That Flattens Yield Curve

(Bloomberg) -- With traders pricing in less than one Federal Reserve interest-rate hike next year after an expected increase Wednesday, strategists at RBC Capital Markets and Morgan Stanley say the bond market may be in for a shock.

RBC’s Michael Cloherty and Morgan Stanley’s Matthew Hornbach expect the Federal Open Market Committee to keep its median forecast for 2019 at three rate increases, while many on Wall Street are leaning toward a markdown to two. That could drive two-year yields up by 5 to 6 basis points in a knee-jerk reaction, and lift 10-year yields by a smaller amount, flattening the curve, Cloherty said.

A three-hike median dot for next year would create “a dramatic gulf between the Fed and what the market is pricing in,” said Cloherty, head of U.S. interest-rate strategy.

Fed's 2019 Path May Produce Surprise That Flattens Yield Curve

Traders have ratcheted back expectations for rate hikes in 2019 amid tumbling stocks and growing doubts about global growth. Still, a quarter-point increase Wednesday is seen as a near certainty even as voices from U.S. President Donald Trump to bond investor Jeffrey Gundlach urge the central bank to forgo a hike.

The market’s immediate reaction on an unchanged 2019 median dot should flatten the yield curve from 2 to 10 years back to about 12 basis points, according to Cloherty, from 16 now. The spread sank to 9 basis points earlier this month, the narrowest since 2007, which is also the last time it was inverted.

Digestion Process

But the response should partially reverse once traders digest the overall picture, which will likely show a downward shift in the pattern of the dots from September even if the median doesn’t budge, Cloherty said.

Bringing the median dot down to two hikes from three is tricky. There’s a new Fed governor, Michelle Bowman, whom Morgan Stanley calls a “wild card.” Even if Bowman lands in the two-hike camp, the median still may not move. At least one of the four policy makers currently projecting three hikes would have to come down a notch. In addition, there were five officials calling for four hikes or more as of September.

“The Fed doesn’t want to be seen as looking spooked by the recent volatility we’ve had, and doesn’t want to be seen as over-reacting,” Cloherty said. “And generally when the Fed stops hiking, it’s hard to get started again. It’s a hard line to walk.”

Wells Fargo strategist Mike Schumacher sees a 10 percent to 30 percent chance the 2019 median dot stays the same, which “could spook the front end.” He says that could cause 2-year yields to climb 10-12 basis points and 10-year yields by as much as 8 basis points in the 24 hours after the FOMC decision. That would flatten the curve by 4-5 basis points.

Even if there’s a downward trend in the 2019 dots, he doesn’t expect that to be enough to calm the market, although Fed Chairman Jerome Powell may be able to use his press conference to downplay the significance of that one dot.

“The market has been looking at a massive reduction in implied tightening for the fed funds rate for 2019, and taken the view that the Fed will become more dovish,” Schumacher said. “If the Fed sticks to a median of three hikes, that’s when the doves cry and the idea of a dovish Fed goes out the window.”

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