Opportunity in trade, inflation and volatility
admin | December 13, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Rates investors have the best chance to see investable opportunity next year on the back of shifts in trade, inflation and volatility. Trade has become a regular tool of foreign relations this year, and recurring tension should keep rates biased below implied forwards. Inflation stands to come in at least above current breakeven rates and, along with possible policy changes, should steepen the yield curve. And periodic episodes of higher volatility next year should keep the value of convexity high.
US trade policy looks likely to keep US rates lower than most investors expect in 2020. Forward rates have the 10-year approaching 2% at the end of 2020, but it should spend more time next year below that mark than above. My colleague Stephen Stanley sees trade friction easing next year, but I am less confident. Trade friction this year helped drive Treasury rates below 2% and should keep rates in 2020 biased below implied forwards. Markets have tended to see trade frictions as isolated and resolvable episodes, but trade increasingly looks like a core part of US strategy for managing international relations. The US has used tariffs or the threat of tariffs this year against Argentina, Brazil, China, the European Union, France, Japan and Mexico and reportedly considered tariffs against Australia and Turkey. The threatened tariffs against Mexico came as part of negotiations on immigration policy, so the US has shown potential to use tariffs for purposes other than economic policy. Last year the US imposed tariffs on imported steel and aluminum from all countries. The US has also tended to move away from multilateral trade agreements in favor of bilateral negotiations more subject to impasse and conflict. Relatively low US economic exposure to trade gives the US initial advantage in most tariff battles, but the joint impact of uncertainty, potential slower global growth and flight-to-quality add up to lower US rates. The Fed’s willingness to counter trade frictions by cutting rates contributes, too. Look for the US to keep the trade pot boiling in 2020, with 5-year and shorter rates especially surprising to the low side.
Absent a broad increase in tariffs, US inflation expectations could surprise to the upside in a few ways. The most interesting would come out of the Fed’s current review of its monetary policy toolkit. Although the Fed has committed to a symmetric 2% inflation target, it has wrestled with realistic ways to let inflation run above that mark, triggering worries that expectations could sink. A number of economists, including former Fed Chair Bernanke, have proposed targeting average inflation. One possibility would be to set intermediate targets that average in the long run to 2%. That seems like a good tool to have in the kit, and a Fed announcement to that effect would likely raise expectations above the 171 bp currently built into the spread between 10-year Treasury notes and TIPS. The most recent minutes from the Federal Open Market Committee suggested results from the policy review by mid-2020. A second likely bump could come from realized inflation. Current inflation is bracketing the implied rate right now. PCE inflation for the 12 months ending in October has run at 1.3%, PCE excluding food and energy at 1.6% and the Dallas Fed trimmed mean inflation at 2.0%. Wage inflation should keep running around 3% to 4% and tariffs should add to broader price inflation in 2020. A Fed on hold through 2020 should have a heavy influence on shorter rates, so the impact of inflation above the pace now implied by market prices should show up more in longer rates. Look for policy and realized print on inflation to surprise to the high side and the 2s10s and 5s30s curve to steepen beyond the slope implied by today’s forward rates.
Policy uncertainty and implied volatility have gone hand-in-hand this year, and the game isn’t over. Some of the uncertainty has come from trade, some from the January and July pivots in the Fed’s path. The Fed path may be more certain in 2020, but the election cycle and the dispersion in tax and fiscal policy proposals should pick up some of the slack. Trade and a potential pivot in fiscal policy should surprise in 2020, driving implied volatility above the current mark on the MOVE index (Exhibit 1). A few good episodes of volatility should keep the value of convexity high.
Exhibit 1: Look for episodes of trade and election uncertainty to drive up volatility
The underlying consensus
Other aspects of the US rates markets look much less likely to surprise in 2020:
Net supply of Treasury debt next year looks likely to tally around $885 billion, according to the Congressional Budget Office. With US real GDP unlikely to vary beyond the bounds of 1.5% to 2.0% and with any new tax or major fiscal policies unlikely in an election year, net supply looks likely to land within fair distance of current expectations.
Demand for Treasuries also looks stable, with no major group of Treasury investors on the cusp of any significant structural change. The domestic holders of 60% of public Treasury debt—individuals, the Fed, mutual funds, financial institutions, pension and state and local government—all should roll into 2020 with roughly the same appetite as this year. The only modest shift may come from the Fed, which intends to reinvest MBS principal into Treasury debt. Major foreign holders including China, Japan and other countries should maintain their Treasury demand.
As growth, inflation and the Fed go, so goes the fair value of Treasury debt. Real growth between 1.5% and 2.0% and inflation approaching 2.0% should put the fair value of 10-year Treasury debt around 2.5%. The prospect of extended trade friction is keeping longer rates suppressed. A Fed on hold should keep the front end of the curve pinned down.
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