In this month's Economic Outlook, Chief Investment Officer Greg Sweeney gives perspectives on Federal Reserve policies, expectations for interest rates and inflation, and what's going on in national and global markets.
Federal Reserve Monetary Policy
The next prospective rate increase is projected to take place at the Fed meeting on December 19. The market is currently placing an 82 percent probability on a 25-basis-point rate hike, which would bring the target rate to 2.5 percent. There is growing concern that the Fed is raising interest rates too fast. This is always a risk with any policy change. From a realist’s perspective, even a Fed Fund rate of 2.5 percent is still “free money” when compared to the inflation rate of 2.5 percent, measured by the consumer price index (CPI).
The most recent year-over-year inflation rate was reported at 2.5 percent. The next data release is scheduled for December 12. With the decline in energy prices starting to make its way into the system, there is a good chance the inflation rate will decline. We estimate we’ll see a rate of 2.2 to 2.4 percent.
Oil began the year at $60 per barrel. The price rose to $76 through early October and has been sloping downward ever since. Oil has a trifecta of factors working against it: uncertain demand, high production output and skepticism about the ability of OPEC to curtail production.
We are a bit puzzled by the number of “risk off” conditions developing and what they may mean for the economy moving forward. “Risk off” is the term the market uses to describe the process of investors moving away from riskier investments and toward more conservative allocations. Investors selling stocks and purchasing U.S. Treasury bonds would be considered a “risk off” activity. Conditions indicating a rotation to more conservative market themes are (1) flattening slope of the Treasury yield curve, which is currently inverted between two and five years; (2) widening spread in the corporate bond market; (3) declining Bitcoin values (we may be alone in considering this a risk off trend); (4) increasing volatility in the equity market; and (5) rising chorus of warnings that the Fed may be raising rates too fast.
Record low unemployment rates, reasonable inflation, high consumer confidence, solid leading economic indicators and stable gross domestic product growth all suggest it is too early to be concerned about these risk off conditions. We are keeping our eye on them.
The big news in the fixed income market is the inverted yield curve between 2 and 5 years. An inverted yield curve occurs when longer maturity bonds have a lower yield than shorter maturity bonds. As this is being written, the yield on the two-year U.S. Treasury bond is 2.80 percent, and the yield on the five-year U.S. Treasury bond is 2.78 percent. Only 10 basis points separate the two-year Treasury bond yield and the ten-year yield, which is currently at 2.90 percent.
An inverted yield curve is significant because it suggests investors are questioning the underlying strength of the economy and arriving at a different conclusion than the Federal Reserve. In turn, those investors are trying to lock in higher, longer-dated yields before yields begin to decline. It may seem odd that a five-year Treasury yield of 2.78 percent is attractive to investors, but after considering other five-year government bond yields around the globe – like Germany at -0.30 percent, Switzerland at -0.60 percent or Japan at -0.11 percent – the U.S. Treasury yield doesn’t look too bad.
Over the last two months, the S&P 500 has been as high as 2930 and as low as 2605. That is a 10+ percent move high to low. As this issue is going to print, the S&P is up 3.3 percent for the year – a mere shadow of the 10.9 percent year-to-date return seen as recently as early October.
In last month’s outlook, we anticipated more volatility going into November. That prediction remains in place for December. The remaining year-end “window dressing” should be wrapping up in the first half of the month, which could usher in a period of market calm in the last half of December. Sustained volatility often encourages investors to consider more boring, value-oriented allocations. We are already seeing some of that take root. Volatility has a way of reminding investors to review their overall portfolio risk profile.
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