04.20.18

GPS anyone? Oil and stock prices are up, the yield curve flattens, and Treasury prices are down

Brian Nick

The past week’s market highlights:

Quote of the week:

“Work eight hours and sleep eight hours and make sure that they are not the same hours.”  – T. Boone Pickens
As part of our new format, we are presenting our featured weekly topics in the context of the major themes listed below from the Nuveen Q2 Outlook:
 
  • U.S. economy: Late cycle has arrived.
  • Global economy: There’s still good news out there.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run, even fewer places to hide.
  • Equities: The bull market’s not over, but expect plenty more volatility.
  • Asset allocation: Valuations are no longer at extremes.
 
Global economy: Rising oil prices, fueled by production cuts, won’t derail growth
 
With crude oil prices at their highest levels since the fall of 2014, it’s natural to wonder about the implications for U.S. and global growth. Rather than attempt to draw conclusions based on the price of oil per se, let’s consider what conditions have allowed the price to rise in the first place.
 
Not surprisingly, the answer lies in a combination of increased global demand and expectations of decreased global supply. On the demand side, global GDP growth remains strong. The International Monetary Fund (IMF) believes global growth is still peaking and may not decelerate until 2020. At the same time, producers have been been focused on reducing the supply glut. Russia and OPEC, for example, joined forces to initiate production cuts in January 2017, a move that helped slash the global surplus of oil by nearly 85%. (Meanwhile, U.S. inventories have fallen below their five-year average.) On April 20, Saudi and Russian officials kicked off a weekend of talks to explore extending their cuts, currently set to expire at the beginning of 2019.
 
OPEC’s “officially unofficial” goal of $80 per barrel for Brent crude oil seems within reach, and a further sustained price increase would be challenging for consumers while creating distinct winners and losers across markets. We’ve already seen U.S. energy-related stocks dramatically outperform the rest of the market this month, after a lackluster first quarter. And high-yield bonds, of which approximately 20% are issued by energy-related companies, have produced a positive return of 1.11% the month (though April 19), besting most other fixed-income sectors. 
 
In 2014, the U.S. economy managed to achieve positive economic growth (2.9%) when crude was over $100 per barrel. This should give us faith that today’s rising prices won’t topple the U.S. into recession. Indeed, the year-to-date climb in oil prices seems justified based on improvements in growth and in the concerted effort by global suppliers to limit their output.
 
Policy watch: Fed hikes are coming
 
Jerome Powell’s ascension to Federal Reserve Chair has garnered plenty of headlines, and rightfully so. However, another key change in the U.S. central bank’s makeup is afoot. In June, acting San Francisco Fed President John Williams will succeed William Dudley as head of the New York Fed—widely regarded as one of the Fed’s most influential positions. His comments, therefore, merit attention.
 
This past week, Williams and several colleagues delivered speeches ahead of the Fed’s latest “blackout period,” which runs from April 21-May 3, the day after the Fed’s May meeting concludes. (During this time, officials will be prohibited from speaking publicly or granting interviews on Fed policy.) Williams said he anticipates longer-term U.S. interest rates will rise amid a combination of Fed tightening, an improving economy, and reduced demand for Treasuries as the Fed’s balance-sheet reduction plan continues apace.
 
He also addressed an issue of particular concern these days: the possibility of an inverted yield curve. Indeed, the yield on the 2-year Treasury—which tends to rise when investors expect more aggressive Fed interest-rate policy—continued its steady ascent, reaching a 10-year high of 2.41% on April 17. Meanwhile, the 10-year note closed at 2.82% that day. This left the gap between the two yields at just 41 basis points, its narrowest since 2007. Yields on 2- and 10-year Treasuries closed the week at 2.45% and 2.96%, respectively.
 
A flattening yield curve sometimes sparks worry that it will actually invert, which takes place when short-term yields exceed long-term yields. Such a phenomenon is rare, often signaling a looming recession. Williams is not concerned about the yield curve inverting this year, given the generally favorable U.S. economic backdrop and his outlook for higher long-term Treasury yields. In his view, some curve flattening is normal as the Fed raises interest rates. For the curve to invert, he thinks markets would also have to lose confidence in the economic outlook. Williams doesn’t believe that has occurred.
 
Meanwhile, based on fed funds futures, the odds that the Fed will hike rates a total of four times in 2018 have reached 50%. This translates to a year-end implied “terminal rate” of 2.24%—the highest it’s been during this tightening cycle.
 
Although a May hike is a long shot, a June move is a near certainty. Beyond that, we see few reasons for a pause in the steady progression of rate increases until late next year. Inflation, as measured by the core PCE index, may soon reach or breach the Fed’s 2% target. (It rose to 1.6% year over year in February.) Also, there is little, if any, slack left in the labor market. With more stimulus about to course through the U.S. economy, inflation might rise further still as unemployment falls below its current 17-year low.
 
Against this somewhat hawkish backdrop, we believe the Fed wants to normalize monetary policy relatively quickly. Therefore, we anticipate three more rate hikes this year (for a total of four) and as many as four in 2019, depending on whether inflation remains at or above 2%. By the end of 2019, the fed funds rate, now at a target range of 1.50%-1.75%, could hit 3% or above.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
 
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