This bulletin won’t include any April Fools jokes nor discuss what is going on in Westminster. I also won’t attempt to make pithy political observations by linking April Fools jokes to the ongoing Brexit drama.
Instead, let us talk about the collapse in USD, EUR and GBP swap rates that started in Q4 of last year and has continued ever since (see chart below).
The 5 year USD swap rate fell from a high of c. 3.1% to its current level of 2.1%. This move reflects the Fed’s softened stance on monetary policy. It now doesn’t forecast any further rate hikes for the remainder of the year and has slowed down the pace of its balance sheet reduction programme.
In the Eurozone, 5 year interest rates went from touching 0.50% to almost -0.10% as the ECB is preparing to launch another lending programme. And while Brexit has already had an undeniable impact on sterling’s interest rate trajectory, the UK is by no means insulated from the dynamics playing out elsewhere. Whatever the cause, the 5 year GBP swap rate has declined from 1.48% in October to a current level of 0.95%.
5 year swap rates for GBP, EUR, USD
Source: Bloomberg, Chatham
A sign of things to come?
The decline in interest rate expectations is worrying as it reflects waning confidence in the broader macroeconomic backdrop by both central banks and markets. To make things worse, the USD yield curve has now partially inverted (see graph below) suggesting short term rates will fall over the next two years. This matters as in the past, yield curve inversion has been one of the more reliable indicators of future recessions, albeit with a lag of about a year or so.
USD LIBOR forward curve
Source: SuperD, Chatham
In summary, the current picture painted by interest rate markets is not very encouraging. The question is therefore whether the drop in rates is the harbinger of worse to come (read: global recession) or just transitory.
If global growth (in particular Chinese import growth) rebounds and stock markets hold up, then interest rate expectations might swing once more in the opposite direction to reflect a more optimistic growth outlook. Avoiding a no-deal Brexit would be a further catalyst for a reversal of the recent drop in swap rates – albeit likely restricted to the UK. This could get us back to where we stood in October last year, just before the markets turned south. As to what will happen to the interest rate trajectory from that point onwards, depends on a number of factors. One is the extent to which the continuing strength in US and UK labour markets eventually creates inflationary pressures. As regards the Eurozone economy, it will have to reduce its reliance on exports and generate sufficient internal demand to sustain a higher interest rate environment.
On the other hand, should the Chinese economic engine sputter, its trade dispute with the US linger on and the UK head for a no-deal Brexit, we might indeed see a recession at some point. This would almost certainly force the Fed and BoE to cut interest rates, and the ECB to keep the refinancing rate firmly below zero for an extended period. As it stands, interest rate markets currently seem to consider such a scenario more likely than a rebound in global growth.
Those currently thinking about hedging interest rate risk face a difficult choice. Relative to six months ago, the current levels could turn out to be a great opportunity to fix your interest. The environment in the aftermath of the Brexit vote is a recent case in point: rates expectations had hit rock bottom as markets feared the worst, but in hindsight, it was a great time to hedge. Since then rates have risen (at least in USD and GBP) and now have much more room to fall again should the economy soften further.
Anyone confronted with the problem of interest rate risk should carefully weigh the downside of being locked into a disadvantageous rate in a recession scenario. Yet those with a longer time horizon and recession-proof assets might well decide that it pays to take advantage of the current swap rates on offer.
Upcoming data releases
This week is quite light on both data and central bank activity. The main releases to watch out for are US Non-Farm Payroll numbers (expected to come in at 175k) and the US unemployment rate (consensus is it will remain at 3.8%). Data on hourly earnings should provide some further guidance on the potential for wage inflation in the US.
For more information, please contact Moritz Sterzinger, Director at Chatham, at email@example.com.