Flat yield curve – so what?

Fixed Income

So much for the U.S. interest-rate cycle. What began tentatively at the end of 2015 and gained momentum at the end of 2016 may now have come to an end after nine minimal interest-rate hikes of 0.25 percentage points each, taking the federal-funds target corridor to 2.25 - 2.5%. On the basis of economic data, the Fed does not currently see any reason to raise interest rates further. Its view shifted late-last year when the Fed Chairman began to suggest the Fed would be sensitive to signs of weaker growth – a stance confirmed when in January theFederal Open Market Committee (FOMC) stated that future-rate steps were "data-dependent". Market participants felt this confirmed their already more cautious view and further reduced their expectations. Meanwhile, the U.S. interest-rate market is pricing one interest-rate hike in the course of the year – our core scenario – with a probability of only 7%. However, bond investors are often quite volatilein this respect. On February 26, markets expected an interest-rate cut only with a probability of 17%; a week later this number dropped to 2.2%. This means investors and the Fed believe the most the U.S. economy can stand at present is a short-term interest rate of around 2.5%. That does not seem an awful lot for an economy that is poised to complete the longest upswing in its history this summer. That also has the lowest unemployment rate in almost 50 years and that is home to nine of the ten most valuable companies in the world. And, in addition, which might grow by 2.5% in 2019. But it needs to run a budget deficit of around a trillion dollarsin order to achieve this growth rate. It is therefore pushing up its record nominaldebt further. Debtors' fear of interest-rate hikes is therefore only too understandable. American students, for example, now hold 1.5 trillion dollars of debt^[1].

The counterargument is that there are good reasons against a return to the nominal interest rates of past decades. Economic cycles have become less and less characterized by capital expenditures (capex) and inventory cycles and are therefore less pronounced. In addition, potential growth is lower, and inflation tends not to pick up. For these reasons, we would also not interpret a possible( but in our view unlikely) inversion of the U.S. yield curve as a compelling signal of recession. The closely observed yieldgap between 2-year and 10-year U.S. Treasuries melted to only 10 basis points (bps) at the end of 2018 and is not much higher now, at 19 bps. Even if we now consider the yield curve to be less meaningful than it was before the financial crisis, the market will continue to follow this indicator nervously. And it is not the only indicator that is wavering close to the danger zone. Even if investors are initially pleased about the lack of interest-rate hikes, the downside is more serious: potentially lower economic growth. With the yield curve oscillating around the zero line and growth averaging only around 2% over the past few years, the strength of the upswing remains constantly in doubt. This also explains the criticism of the Fed's tightening on "autopilot" tightening before its recent change of opinion.

This dichotomy – less risk of interest-rate hikes versus a bleak economic outlook – is the framework for our forecasts. We think the market is somewhat too pessimistic. We expect U.S. Treasury yields to rise slightly to 2.75, 3.00 and 3.20% for the 2-, 10- and 30-year maturities by March 2020. We have lowered our yield forecasts for Bunds to -0.40 (2 years), 0.30 (10 years) and 0.80% (30 years) to reflect the expected further delay in the first interest-rate hike by the European Central Bank (ECB) and lower growth expectations. For corporate bonds, the U.S. market looks attractive from a carry perspective, even though we do not expect any further spread narrowing. Euro corporate bonds continue to benefit from a lack of alternatives and solid corporate balance sheets. In emerging markets (EM) we continue to see investment opportunities. In EM we like corporate-bond issuers from Asia and occasionally South America; in government bonds we continue to regard stable issuers from Eastern Europe and certain higher-yielding issuers from Africa, for example, as attractive. But remember to be very picky in these regions, as they are very heterogenous.

A yield curve below zero (inverted yield) is still seen by many as a harbinger of recession. However, we believe that the curve has become less meaningful.

Sources: Thomson Reuters Datastream, DWS Investment GmbH as of 2/26/19

While markets are quite optimistic that the Bank of England will raise rates this year, they are less confident about the ECB's and the Fed's future steps.

*central-bank meeting in 2019 with a possible interest rate decision

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 3/5/19

Currencies

First things first: in the euro-dollar currency pair, that is probably decisive for many of our readers, it currently looks like a draw. Our 12-month forecast therefore remains at 1.15 dollars per euro. Although the dollar may begin the game with the better cards while Europe holds a few weak ones (Brexit, Italy, European elections), the game could turn in the second half, i.e. from summer onwards. In the United States, the effects of the stimulus packages are fading, the twin deficit continues to rise, and the pressure on Trump is likely to be rising, while we expect economic activity to pick up in Europe. In addition, the prospects for a further widening of the interest-rate differential between the U.S. and Europe have narrowed thanks to a more dovish Fed.

Compared to these two politically volatile regions, Japan appears tranquil. We believe this could boost its traditional reputation as a safe haven this year. In order to hedge against the many known and yet unknown risks, we currently view using the yen vs. the euro as a good option. We expect it to rise to 123 yen per euro by March 2020.

Another currency that we will be watching closely over the next twelve months is the yuan. Although so far this year it has risen against the dollar, we see it returning to around 7 Chinese yuan per dollar. We do not expect it to go beyond this threshold as in our view this would not be acceptable to the Beijing leadership on the 70th anniversary of the formation of the so-called People's Republic of China.

In capital markets, few correlations are as reliable as the one between Japan's currency and its equities, many of which rely heavily on exports.

Sources: Thomson Reuters Datastream, DWS Investment GmbH as of 2/26/19

* Topix

** J.P. Morgan Japan NEER Nominal - Trade Weighted Index