The guy who predicted the 10-year would fall to 1.50% now thinks it's going even lower
Bloomberg
In two days of Congressional testimony, Chairwoman Janet Yellen maintained that the Fed is still on track to raise interest rates. While acknowledging that financial conditions in recent weeks had created downside risks, she remains optimistic on economic growth prospects.
Could problems with the banking sector depress US growth? Not really, because the decline in energy prices and the plunge in emerging market valuations hold only limited risk for the US banking system.
And if you have a lingering doubt about whether the Fed rate hike on December 16 has anything to do with the ongoing market turbulence, Yellen has a firm answer: NO!
The Chairwoman was just not convincing. Having been repeatedly proven wrong in expecting inflation to head toward the Fed’s 2% target, she repeated that expectation despite plummeting energy prices. And even though the Fed rate hike in December prompted a surge of capital outflows from China that month, Yellen wouldn’t admit that the Fed made a mistake. A record fall in Chinese official FX reserves at year-end led the government to depreciate the currency further in early January, encouraging even more outflows last month. The correction in Chinese equity prices was a major factor in the global market turbulence. Yellen did not explain why all these developments occurred immediately after the Fed’s ill-advised rate hike.
What did financial markets think of the Fed move? The Dow Jones Industrial Average fell by more than 400 points as the Chairwoman was testifying, closing the day with a smaller loss only because a Middle East oil minister was rumored to say that OPEC may hold a meeting to cut output. US bank stock prices were especially hit due to fears about the quality of their loans, and growing worries that the Fed rate hike and the global turbulence could push the US economy into recession. Markets took the concerns about the capital adequacy of specific European banks, and the fear of contagion to US institutions, more seriously than Yellen’s reassurance that the US banking system was in sound shape.
BloombergThe most important Two-Thumbs Down came from the bond market. The 10-year Treasury plunged to 1.53% at one point during Yellen’s Senate testimony, just above the 1.50% target I have publicly discussed for several months. Plunging bond yields belie the Fed’s expectations that economic growth prospects are still in good shape, and that inflation is headed upward. Instead, the bond market is saying that the risk of a recession is growing, and that it sees little prospect of the Fed attaining its 2% inflation target.
What will the Fed do in coming months? With the ECB and the Bank of Japan having opted for negative interest rates which may turn more negative, the Fed has little chance of being the lone ranger in hiking rates again. If US rates remain unchanged through year-end as the two other major central banks lower rates further and/or introduce additional QE, the dollar will once again strengthen big time. Faced with a slowing global economy and faltering US export prospects, implementing policies leading to a stronger dollar would be political suicide for the Fed. I expect the Fed will first cancel the rate hike of mid-December and, after returning to ZIRP again, adopt negative interest rates.
Yes, the Federal funds rate will likely go below zero. And the 10-year Treasury? Go past my 1.50% target toward my new target of 1.00%.