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Treasury yields have whipsawed recently as investors are at odds with the present situation of the economy and the potential downside risks
Over the past two months, we have witnessed some abnormally large swings in the direction of interest rates. The 10-year Treasury has been whipsawed from the 2% level down to 1.50% and back up to 1.90% by the middle of September. The bottom line is, there is a tremendous amount of uncertainty that has built up in the markets which has been driven by a multitude of factors. Central banks have pledged to support economic growth to the extent they can, but they have been reluctant to meet market expectations for monetary stimulus. Both the Fed and the ECB cut rates in September, but market participants were expecting more than what was delivered. In turn, we saw interest rates fluctuate dramatically as investors weigh the timing of monetary stimulus with the expectations of slowing growth. While the Fed has yet to come to a consensus on when to end policy easing, it is likely we will see an additional rate cut before year end. On balance, we still expect the 10-year Treasury to remain within our forecasted range at year end as further easing has already been priced into the market.
A divided Fed continued with their mid-cycle adjustment to policy rates by cutting the Fed funds target by 25 basis points
Regarding the Fed, a rate cut at the September meeting was virtually a shoo-in as most market participants had already priced a 25 basis point rate cut as a foregone conclusion. What mattered more to investors was how the dot projections were going to play out and what sort of guidance Chairman Powell would provide with regards to his mid-cycle rate cut. When assessing the current backdrop, the bifurcated U.S. economy, in which slowing business investment is being offset by strong consumer spending, made it difficult for the committee to make a clear commitment to further easing. Most noteworthy, there was much division among Fed members as to whether rate cuts were warranted against this backdrop as three Fed officials dissented, two were in favor of not cutting, and one in favor of a 50bps cut.
Headline risks continue to drive markets and equities fared well during September as the rhetoric surrounding the U.S.-China trade negotiations has turned positive
Equity investors were the clear winners during the month of September as positive economic data on the consumer coupled with fresh monetary easing from the Fed helped support equity prices. The rhetoric surrounding the U.S.-China trade negotiations has turned positive, which has given investors some hope that some progress or an agreement can be reached during the next round of negotiations. Overall, despite ongoing end-of-cycle pessimism priced into the rates market, equities have remained elevated and will likely remain so until an impending recession is upon us.
Recent stress in the short-term funding markets has caused the Fed to intervene with temporary open market funding operations, but the recent development isn’t viewed as a systemic concern
The story catching the most attention last month came from the inconspicuous repo funding market. For those of you who are not familiar, the repo funding market is where banks and other firms on Wall Street lend high-quality securities like Treasuries as collateral in exchange for cash to fund short-term obligations. Resulting from a combination of large tax payments and bond settlements, there was a shortage of cash on dealer balance sheets, which ultimately put swift upward pressure on short-term funding rates. The overnight borrowing rate spiked to 10% before the Fed ultimately stepped in to provide emergency liquidity through its own repo program. While some investors are quick to draw similarities to the liquidity episode during the financial crisis, it’s important to note that banks are too well capitalized today to make this episode a broader concern. Overall, we don’t believe there is a systemic concern for banks to attain short-term liquidity, but we do believe the Fed will likely need to address some structural changes to their balance sheet in the near future.
The views expressed above reflect the views of Allianz Investment Management LLC, as of 10/2019. These views may change as market or other conditions change. This report is not intended and should not be used to provide financial advice and does not address or account for an individual's circumstances. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Allianz Investment Management LLC is a registered investment advisor that is a wholly owned subsidiary of Allianz Life Insurance Company of North America. Allianz Life Insurance Company of New York is also a wholly owned subsidiary of Allianz Life Insurance Company of North America.