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By Saikat Chatterjee and Dhara Ranasinghe
LONDON, Dec 4 (Reuters) - The dollar has peaked against the euro as the Federal Reserve nears the end of a multi-year rate hike cycle with a potential inversion in the bond yield curve a sign of recession risks in the world’s biggest economy, a major investor said on Tuesday.
Bob Michele, who heads global fixed income for JP Morgan’s investment arm, said he doesn’t expect the U.S. yield curve to invert, because the effects of the tax stimulus are still rippling through a broadly healthy economy and supply looms large in the months ahead.
This week has seen two-year U.S. Treasury yields rise above five-year bond yields for the first time in more than a decade. The gap between 10- and two-year U.S. debt yields is close to turning negative, a classic recession indicator. (tmsnrt.rs/2RuCkDH)
The drop in longer-maturity yields — 10-year U.S. yields are trading at 2.94 percent, their lowest since September — comes at a time when the market is prepared for a large dose of supply to fund a growing fiscal deficit despite tepid inflation.
“It (the yield curve) has certainly got my attention,” Michele told Reuters. “Right now we’re not expecting a recession, especially if the Fed does pause.”
But he added that if the curve did invert in the face of hefty supply, that “tells you something is happening beneath the surface.”
Michele expects the Federal Reserve to raise interest rates twice in 2019 before ending a three-year rate-hike cycle around 3 percent.
That compares with current market expectations for one more rate increase next year but is at the lower end of market estimates. Some economists believe the Fed will raise rates as much as four times next year.
Michele also expects the European Central Bank to lift rates as much as twice next year, a view that is far more hawkish than euro zone money markets. They price in less than a 70 percent probability of one 10-basis-point increase hike in 2019.
“We are going to hear sooner than later from the ECB that it will begin its journey towards zero and slightly positive interest rates next year,” he said.
Michele added that additional Targeted Longer-Term Refinancing Operation (TLTROs) — essentially cheap multi-year loans to banks — from the ECB are a “real possibility” to support the economy.
Higher rates will also help the euro rise from a near 1 1/2- year low hit last month, with the added benefit that a drop in global trade tensions would help Europe more than the United States, thanks to a weaker currency boosting exports.
On Italy, Michele, who oversees some $491 billion of assets under management as of the end of June, said that Italy’s problems will be solved before a standoff between Rome and the European Union escalates into a crisis.
Growing signs in recent weeks that Italy’s anti-establishment government is willing to reach a compromise over its expansionary budget has lifted battered Italian bonds.
“They (the ECB) can provide the liquidity and backstop the market and it’s not a big issue for them,” said Michele, who believes Italian yields offer value at current levels.
He also believes emerging-market debt looks attractive, especially in Indonesia, South Africa and Mexico, where assets have been caught in a selloff since summer and where central banks are still comfortably raising rates.
“It looks like the tourists in the asset class have been washed out,” Michele said.
The only source of concern for emerging markets would be how China responds to a slowdown in economic growth. A weakening of the Chinese renminbi or additional fiscal stimulus might weigh on emerging-market debt.
On British government bonds, Michele remained underweight, citing the risk of a Bank of England rate hike in the second quarter of 2019 if Britain negotiates an orderly Brexit. (Reporting by Saikat Chatterjee and Dhara Ranasinghe; additional reporting by Karin Strohecker, Tom Finn and Julien Ponthus; editing by Larry King)