This past week, the Fed raised its fed funds rate band up 0.25% to 2.25%-2.50%. Immediately after this was announced, not only did stocks sell off, but the yield curve also flattened further as markets repriced their outlook on global growth.
Many in the markets focus on the shape of the yield curve as some see it as the best predictor of an impending recession. This historic fact has created a negative feedback loop for investors where concerns about the economy flattens the yield curve which then creates more concern about the economy.
In fairness, the shape of the curve does impact the ability for banks to make profitable loans and thus could dry up liquidity as banks pull back on lending. However, when using historical performance to predict future returns, it is important to consider whether conditions have remained the same.
To this end, the Federal Reserve Bank of Richmond took a look at the term premium (extra interest that investors demand to hold longer term assets). In its study, the Fed found that the term premium (TP) has shrunk over time with the average TP since 1961 at 1.6% and at 0.20% since 2012. Put another way, the yield curve has a 46% of inverting in any given month at the post 2012 TP level. However, if the TP were to return to it post 1985 average, this probability drops to 10%.
Clearly, this analysis is an over simplification of a complex question, but it does provide a good point. In a world where the TP remains low, the frequency of inversion is expected to increase despite the chances of a recession remaining the same.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
There are no Key Central Bank meetings this week
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
New Home Sales
Expectations for a gain from 544k to 569k
Expectations for a decline from 135.7 to 133.4
Expectations for a decline from 66.4 to 61.0
Expectations for gain of 0.3% after a gain of 0.1%
Asia/Japan, and New Zealand
Japan Jobs Report
Expectations for the UR to remain at 2.4%
Japan Industrial Prod.
Expectations for a decline of 1.7% after a gain of 2.9%
Despite all the raw emotion in equities and interest rates, the EUR and DXY remained trapped within recent ranges to the surprise of many. Failed attempts at both bullish and bearish breakouts run out of momentum within 24 hours and fold back to the center. We remain tilted toward a more bearish U.S. dollar view and believe the EUR is nearing a bottoming phase.
The GBP too continues to consolidate like the EUR but with a downward bias. Continued uncertainty surrounding the Brexit negotiations and an upcoming Parliamentary vote continue to undermine confidence and sentiment regarding the GBP. Expect further consolidation until the Parliamentary vote during the week of January 14.
Since equities peaked on October 3, the Japanese yen is one of the top performing major currencies appreciating by nearly 3%...the euro is fractionally lower and the CAD and NOK are down nearly 5.5% for a comparison. A full-risk off environment and sharply lower U.S. interest rates have made this currency a safe haven once again. Expect consolidation next week.
The CAD continues to remain very weak ever since U.S. and global equities began to spiral lower in early October. The market perceives that Canada is tethered more to the U.S. economy than other commodity linked currencies. Add into the mix the fact that oil prices have collapsed and the CAD has been on a one-dimensional path of weakness for almost three months. Expect consolidation next week with many centers on holiday. RBC’s new range for Q1 is 1.3600-1.3100 so we are near the top end of that range.
The CNY has managed to remain in a relatively narrow range despite all the upheaval in equities, interest rates and related Asian currencies. Expect the Chinese authorities to keep the CNY within recent ranges with a bias toward further weakness.
The AUD has been on a roller coaster ride since October. The NZD has been one of the top performing currencies since October 3 exerting a positive pull on the AUD. Conversely, currencies like the CAD, NOK and other commodity linked currencies have been extremely weak pulling the AUD into the opposite direction. Aussie is currently testing yearly lows; expect some consolidation this week and more whipiness.
Want to learn more about international finance, economics, and global events? Sign up for our other Foreign Exchange emails and videos!
Follow City National Bank on social media:
Investment and Insurance Products:
Are Not insured by the FDIC or any other federal government agency
Are Not deposits of or guaranteed by a Bank or any Bank Affiliate
May Lose Value
This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. The Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.
Tune in for a guide to ETFs and investing strategies for potential long-term success. View in a browser Fidelity Fidelity Log in Creating a portfolio with ETFs: Why and how Creating a portfolio with ETFs: Why and how