How low can you go?
This has all escalated very quickly. The environment has become bond bullish and yields are collapsing. There is a growing anticipation that the Federal Reserve will need to ease policy in the coming weeks and months. If equity markets fall further and credit spreads widen, this could happen sooner rather than later. The immediate concern is the trade war between the US and China. The more fundamental concern is the lack of inflationary momentum and concerns about the effectiveness of monetary policy. A return to balance sheet expansion can’t be ruled out at some point. For the headline writers, China’s retaliation to US trade policy, the Italian budget, and the UK’s political farce are additional reasons to spread fear and loathing. Long duration is where to be.
It is clear that recession risks are rising. The consequence of that is that bond yields are likely to keep falling and credit spreads are likely to continue to widen until the US Federal Reserve cuts interest rates. Rates markets have moved a lot already this spring – German bunds just printed an all-time low yield of -20 basis points (bps), 10-yr UK gilt yields are below 90bps, and Spanish debt is trading with a yield of just 74bps. The US yield curve is inverted between 3-month money (2.36% for Treasury bills) and 10-year debt (2.17%), and the market is now pricing in at least two rate cuts this year with a 68% probability of a rate cut in September. However, the worry is that risk markets have not moved to price in the significant downside risks to the economic outlook. The S&P closed on May 30th at 2788.86, just 4.5% lower than the high it reached at the beginning of the month. This needs to be compared to the 20% peak-to-trough decline that occurred in Q4 of last year. On the credit side spreads are wider but are well below the levels reached in December. The nearest thing we have had to a recession in recent years was in late 2015 and early 2016. US investment grade credit spreads topped out at 221bps. Today they are 131bps. For US high yield the comparison is 887bps versus 433bps.
It is difficult to believe that it has been the Fed itself that has brought this situation about. It raised rates by 250bps this cycle, which is much less than in previous cycles and over a longer period than normal. In both nominal and real terms, the Fed Funds policy rate is lower than prior to any previous recession. Capital market yields hardly got that high either, with 5-year US Treasuries peaking at 3.1% last year and investment grade credit yields at 4.4%. Given that nominal GDP growth averaged close to 5% in each of 2017 and 2018, monetary conditions were hardly restrictive. If the Fed had carried on raising rates, like it threatened before last December, then maybe it would have been mostly responsible for engineering the slowdown, but it hardly seems to be the case. Instead we have to look at the combination of an increasingly hawkish US foreign policy (including trade), political fragmentation in Europe, and the difficulties China has had in dealing with imbalances in the state-owned sector. More specifically, President Trump’s trade policy is negatively impacting global trade flows, supply chains, and business investment. I was optimistic that the expansion could continue, but now I am not sure at all. Confidence is eroding amongst businesses and investors.
Watch the data
The data is starting to scream “downside risks”. The US Institute for Supply Management (ISM) has fallen from a peak of 60 last June to an April reading of 52.8. Typically, the ISM manufacturing index falls well below 50 in a recession so the next couple of prints for this data series will be interesting. Historically, bond yields have followed the ISM index and a decline below 50 in the next couple of months would be consistent with 10-year Treasury yields below 2%. In fact, looking at a de-trending time series of the bond yield against changes in the ISM suggests that a range of 1.5-1.7% for Treasuries is not out of the question as a target if macro momentum continues to be weak. However, this is not likely to happen without the Fed cutting interest rates. Historically, a negative spread between 10-year Treasuries and the Fed Funds has pushed the Fed into easing. The most recent example of this was in 2007. From mid-2006 the 10-year yield went below the Fed Funds rate, reaching a level of -70bps at one point. The Fed eventually cut rates in September 2007.
Elsewhere there are warning signs. It was reported this week that May saw a rise in the German unemployment rate for only the fifth month since 2009 and for the first time since November 2013. This is clearly linked to the weakness in the German manufacturing sector and specifically the auto industry. The German manufacturing purchasing managers’ index fell from a peak of 63.3 in December 2017 to a most recent reading of 44.3. A near 20-point drop in such an index is a sign of a serious slowdown and given that the level of German GDP fell in the second half of last year, it is not unreasonable to say that Germany is in recession already.
Other reasons to be fearful
There is a long list of other factors to worry about. Brexit is no closer to happening and the long-predicted fragmentation of the British political system is happening before our eyes. The political paralysis is having a parallel impact on the corporate sector with investment spending already weak for some time now. Again, business leaders have warned the political elite against allowing a “no-deal” Brexit and they are unlikely to increase corporate spending until there is some confidence that “no-deal” is 100% off the table. On the continent it looks as though the Italian situation is bubbling up again with the EU and Rome going head to head over Italy’s fiscal position. The Italian government bond spread to Germany has been creeping higher as a result. On top of this is a general increase in geo-political tensions mostly linked to a more hawkish US foreign policy. The most recent threat from the White House, to impose a 5% tariff on Mexican exports to the US, suggests that Trump is in no mood to ease tensions on trade or in any other areas of diplomatic relations.
And then there is China. As I write we await China’s response to US trade sanctions after it has already threatened to restrict exports of rare earth minerals. This makes the outlook very uncertain and it is not clear that the US will eventually get its way, despite Mr Trump appearing to treat the trade dispute like a New York City real estate deal. China’s manufacturing purchasing manager’s index fell back in May and is just below 50 and there has been a clear hit to both export and import growth since the US first imposed tariffs. The pressure has been offset to some extent by what looks to be a very convenient adjustment in the external value of the yuan since April and, of course, this is still a weapon that Beijing could use to offset any further escalation of the trade war. At this stage I don’t see much chance of China doing anything with its vast stock of US Treasuries (selling large amounts would push up the value of the CNY and create financial turmoil in the US, both of which would be detrimental to China) but that remains a risk in the future.
Back to the central bank drawing board
Underlying these political and cyclical concerns is the more worrying fear that the global economy remains in a long-term deflationary state. The inflation data are amazingly weak. The Fed’s core personal consumption deflator measure of inflation printed at just 1.0% annual rate in the first quarter against economists’ expectations of 1.3%. In the UK, consumer price inflation was lower in April than most had forecast with the core rate running at just 1.8%. Preliminary state level inflation data in Germany, released on May 31st, all came out lower than expected. Part of the decline in long-term bond yields must reflect growing pessimism about the ability of central banks to generate inflation close to their long-term targets. In the US and Europe, market based inflationary expectations are falling rapidly. With interest rates close to, or below, zero in most of the developed world the concern for investors is the limited firepower that central banks have. So, all eyes are on the Fed to provide the first bit of renewed monetary stimulus. What follows may need to be something more radical. One thing is for sure, interest rates are not going up.
Risk-off, duration on
Slowing global growth, underperforming inflation and policy biases that are impacting negatively on business confidence suggest bond portfolios should be weighted more towards higher credit quality and longer duration. There will be opportunities to add credit risk again, but more than likely this will be at wider spreads and, more than likely, will be following some new policy initiative from global central banks. For now, locking in the gains made in credit markets already in 2019 looks to be a sensible strategy. On the optimistic side, there could be a trade deal, the world economy might turn out to be more robust than we think, and some of the increases in wage rates that have been observed in several countries could eventually feed through to final inflation. But at the moment, this is clutching at straws.
There should be a better atmosphere at the Champions’ League final in Madrid than there was at UEFA’s junior event in Baku this week. Congratulations to Chelsea and especially to Eden Hazard for a game winning performance. Saturday’s match is hard to call, with Liverpool slight favourites in the betting markets. It will be hard to match the drama of the semi-final games but hopefully it can. Madrid is a great city to host such an event and the relatively new Wanda Metropolitano stadium is spectacular (more Tottenham Hotspur Stadium than Anfield, if that matters) and a fitting venue to what should be the showpiece game of European football. I know who I want to win but all I am going to say is enjoy the game. Now, can I get Chas and Dave on Spotify?
Have a great weekend,
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