Financial markets have undergone a pretty sharp shift over the past two weeks. Interest rates have rallied while risk assets like credit, equity, and emerging markets have underperformed. Volatility measures are higher, and the Treasury yield curve is now largely inverted.
Invesco Fixed Income believes that several market drivers are at play, in the following order of importance:
1. Elevated trade tensions that reduced global growth forecasts
2. Uncertainty over Federal Reserve (Fed) policy — will the Fed ease aggressively or is it “behind the curve”?
3. Mixed global economic performance
Can the Fed ease the market’s concerns?
Over the past two weeks, perceptions of the Fed have changed. At first, it seemed that the Fed was keeping up with market easing expectations; now, it appears the Fed is falling behind amid declining growth expectations. The driver of this change has been increased trade uncertainty and a weakening global growth outlook.
The inversion of the Treasury curve (when shorter-term Treasury yields are higher than longer-term Treasury yields) suggests that the market is urging the Fed to accelerate its easing program or else face the risk of recession. Without further easing, the market believes tightening financial conditions could drag down consumption. With capital expenditure spending already relatively weak, a consumption decline could risk pushing the US economy toward cyclically low growth rates.
We believe it is becoming increasingly difficult for the Fed to “out-dove” market expectations and generate truly easier financial conditions. For example, the market is currently pricing in a roughly 50% chance of a 50 basis point rate cut in September.1 To “out-dove” that expectation, the Fed would have to deliver a 50 basis point cut and provide further dovish guidance to the market, or deliver an intra-meeting cut. We believe this is unlikely.