Much speculation and anxiety had been running through global financial markets in recent months regarding the prospect and timing of the Federal Reserve’s inaugural tightening of U.S. monetary policy. In the months leading up to the March Federal Open Market Committee (FOMC) meeting on March 18 as investors weighed the implications of the Fed’s carefully chosen words, such as “patience” and “data-dependent,” the U.S. interbank interest rate swap curve steadily migrated toward concluding that a tightening of monetary policy was inevitable in 2015. The two-year interest rate swap yield traded between 90 basis points (bps) and 98 bps in the first two weeks of March and reached the highest levels seen since the start of second-quarter 2011. Even after the surprisingly dovish overall tone of the March FOMC meeting press release, two-year swap yields of 85 bps as of March 19 remain considerably higher than the sub-50 bps levels seen one year ago (see chart below).
If U.S. 10-year swaps were currently trading at comparable 2011 levels, the yield would be 3.58%, or 158 bps higher than the current 2.00% yield. At first glance, considering that the U.S. economy is considerably stronger today than in 2011 and that a prospective Fed rate is still more likely today than at any point since the economic recovery began in 2009, the relatively low 2.00% 10-year swap yield appears to be an anomaly compared with the 358 bps recorded on April, 1, 2011. Because Global Markets Intelligence (GMI) Research firmly believes that financial markets are almost always appropriately valued over the short- to intermediate-term, the relative outperformance of intermediate- to longer-term interest rates during the past year signals that the majority of investors believe that:
- The U.S. economic recovery will continue on the moderate 1%-3% GDP growth rate trajectory recorded since the recovery commenced in 2009.
- U.S. core inflation will only gradually gravitate toward the Fed’s 2% target rate over the balance of this recovery cycle.
Future interest rate changes and developments, such as the slope of the U.S. dollar interest rate yield curve, will now depend entirely on the U.S. economy’s true underlying health and dynamic nature. As has often been the case since 2009, U.S. economic data has recently looked somewhat mixed. The housing market remains unimpressive overall and retail sales (excluding gasoline) have flattened since November; however, the pace of job creation has risen to the best levels seen in more than a decade. Based on the vastly improved pace of non-farm payroll job creation, GMI remains optimistic about the prospect for improving GDP growth for the rest of this elongated recovery cycle. Declining unemployment combined with the crude oil-based household tax cut should allow resumed gains in personal income and consumption during 2015.
Investors should pay particularly close attention to future incremental developments in the pace of job creation, wage growth, and prospective inflation risks that have been fleeting and largely absent since the beginning of this recovery. According to the Fed’s economic projections released after the March FOMC meeting, inflation is now expected to range between 0.6%-0.8% in 2015, which is considerably lower than the 1.0%-1.6% range the Fed envisioned at year-end 2014. This implies that rate hikes can now easily be pushed back into 2016 from the late 2015 presumptions that existed in the marketplace prior to the Fed’s March meeting. The current term structure of rates implies a fairly benign intermediate-term outlook, but as we have witnessed many times in global financial markets, perceptions and thus market reality can change quite rapidly, as evidenced by the past year’s largely unanticipated collapse in crude oil prices and the meteoric ascent of the U.S. dollar in the global foreign exchange market.