Strong returns

It has been a bit of rollercoaster year for US treasuries. Ten-year US treasuries spent most of 2018 underwater, touching total returns of -5 per cent in May and October. But they ended November in near-positive territory for US dollar total returns (chart 1) as the US economy showed signs of softening. That said, returns are still negative when hedging costs on other currencies like GBP or EUR are considered.

Still, one cannot ignore a 4.5 per cent return achieved by 10-year treasuries from the recent lows at the beginning of October, together with strong returns in bunds and gilts (3.1 per cent and 3.7 per cent respectively in local currency terms) during the same period.

Source: Bloomberg, Fidelity International, December 2018.

Tightening yield curve

Not many would have predicted flat total returns in US treasuries for the year a few months ago, with US GDP growth cruising at 3 per cent. The final push from the Federal Open Market Committee (FOMC) on Wednesday was a critical factor. Fed Chairman Jerome Powell was more hawkish than expected, projecting “some” further gradual increases next year. The market was hoping for a more dovish hike rather than the semi-hawkish one received, even though the Fed reduced the number of expected increases in 2019 from three to two.

The market anticipates a more dovish path still, pricing in only three quarters of one 25-basis-point hike next year. The so-called ‘Powell put’ is not evident for now and the yield curve continues to tighten. With the 2-year/10-year treasury spread at 12 basis points, 4 basis points or so lower than pre FOMC meeting, we are now approaching the lows in this cycle. Another popular measure of the yield curve, 10-year yield minus the Fed Funds rate is now at 40 basis points (it was 140 basis points in the first quarter).

Source: Haver Analytics, Fidelity International, December 2018.

Slowing US growth worries

For some time now, we have been expecting the tailwinds behind 2018 US growth to gradually correct into the second part of 2019. The fading tax stimulus impact is most likely to weigh on growth and risk assets’ performance. Interest rates are 125 basis points higher this December compared to the same time last year. While this is a relief for USD savers, increased rates are starting to have an effect on real activity.

Anaemic capex investment is also unlikely to keep US growth above trend for much longer. Signs of vulnerability are already appearing in the housing market, in part due to higher mortgage costs. And while the corporate sector remains in decent shape, signs of cost inflation will not help the bottom line

Santa’s rally did not come for stocks this year, but government bonds have had a better run up to Christmas and the year is not over yet.

Claudio Ferrarese

Claudio Ferrarese