The continued effects of US yields can be felt across the entire asset class today. Following Friday, we are seeing risk sell-off in FX, equity indices and bond yields. The FX risk basket of TRY, BRL and ZAR have been hammered with the JPY as the primary destination for safe-haven flows. The yield on the 3 Month Treasury Bill rose above the yield for 10-year Treasuries for the first time since 2007, generating forewarnings that the US is headed for recession in early 2020. The move was generated by FOMC dots indicating solid expectations for a pause in 2019 and raising the probability that the next move will be an interest rate cut.
Historically, yield-curve inversions precede significant economic slowdowns by about a year. While some high-status pundits have suggested that it's different this time, the actions have already triggered a self-fulling prophecy. The San Francisco Fed's Michael Bauer and Thomas Mertens wrote last year that the "the traditional 10 yr-3-month spread is the most reliable predictor (of recession)". Note: The US 10-year, 3-month curve inverted ahead of the 1990-91, 2001 and 2007-09 recessions.
On the policy side, we believe that the Fed will pause its currency hiking cycle indefinitely. Core PCE (Personal Consumption Expenditure) inflation has been running below 2% y/y so there is little need for the FOMC to be aggressive. In addition, the growth slowdown indicates that any overshoot would hit meaningful headwinds. The theory of no further hikes this cycle is also supported by the fact that unconventional policy in balance sheet reduction has also turned dovish. Yet the Fed's concern is less about growth outlook, which has remained solid but at risk to financial conditions. Instead, it seems to have become hypersensitive to risk in the financial markets. This outlook should be USD negative, however, as there is increasing worry that Europe and the ECB are not behind the curve. We don't expect the ECB to cut rates any time soon but the outlook for tighter Euro-area monetary policy is now fading. Our US-EU convergence theory that would have given the Euro a boost need to be side-lined.
