Banging the recession drum | Financial Times

Banging the recession drum | Financial Times

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When the bond market bangs the recession drum, everybody listens. Beyond a very active debate over whether the latest US Treasury yield curve inversion matters (yes it does), the near-term story for markets is just how nasty financial volatility becomes with a couple more weeks left to run in August. 

Having spent a relaxing week in the Tirol Mountains, hiking up the ski runs that overlook Innsbruck and Hall, bond yields have remained in hammer mode during my time off. On Thursday, the US 30-year Treasury bond yield dipped below 2 per cent for the first time, since regular sales of the issue started in 1977. Entering the 1 per cent club, leaves just Italy (around 2.50 per cent) as the only major economy with 30-year bonds with a higher yield. 

The latest leg lower in yields earlier on Thursday was triggered when China said it plans to “take necessary measures to retaliate” after the recently announced US tariff escalation. That was followed by more soothing lines about how the US and China are still talking over trade, but unease remains the underlying story in markets. A modest recovery on Thursday for Wall Street, was led by utilities and consumer staples, while the poor performance of transport stocks is standing out. Also on investors’ radar screens is the very tense situation in Hong Kong and what steps China ultimately takes to resolve matters. 

Hardly surprising against this backdrop is how the pain in carry trades has only increased in recent days, with Brazil, South Africa and Mexico leading the decline among leading emerging market currencies. A hot August is a testing time for global investors who have taken a walk on the wider side of the risk spectrum. Tighter US dollar liquidity for the global financial system is not fading anytime soon with the Treasury set to sell a lot more debt and crowd out other borrowers.

The rise in market volatility is highlighted by US Treasury bonds. Implied Treasury volatility over the next 30 days has reached its highest level since November 2016. The Merrill Lynch MOVE index has jumped from a reading of 55 at the end of July and sits just shy of 90. Since late 2009, forays beyond 100 (such as the taper tantrum of 2013 and the US sovereign debt downgrade by S&P in 2011) have been rare.

Clearly, risk aversion is running hard, but we may well have reached a limit for now, looking at MOVE. And the current combination of low interest rates and robust employment data, is keeping the US consumer ticking over, although manufacturing looks less promising. The latest US retail sales data for July were robust on Thursday. That duly clipped the bond market, and briefly sent the 30-year Treasury yield back over 2 per cent before a surprise drop for industrial production renewed the bid for government debt. At one point, both US two-, and 10-year yields dropped below 1.5 per cent, while 10-year real yields (adjusted for inflation and a barometer of future economic growth) turned negative and closed under zero for the first time since July 2016. Italian bonds were also in demand on expectations of hefty stimulus from the European Central Bank next month. 

The question remains how long can the US stand apart from the global pack. What’s powered the latest and pronounced decline in yields is the recognition that the global economy is not set for much of a second-half recovery (a consensus call until recently) as the slowdown in China is not abating. The canary down the coal mine here for investors is a slumping German economy that is highly sensitive to Chinese demand. 

This is problematic for equities, and why the bond market messages via an inverted yield curve and the clamour for long-dated bonds is worrisome. Sure, plenty of people are talking down the message of an inverted yield curve, hardly a surprise to anyone who can recall similar rebukes from 2000 and 2006, but a pronounced period of inversion has paved the way for a recession 12 to 18 months down the line.

Chris Iggo at AXA Investment Managers sums up the current thinking in fixed income via his latest weekly note:

“Investors need safe assets and have woken up to the value of long-dated bonds in terms of protecting capital and delivering positive returns when equities are under pressure. Investment strategies based on the expectation of strong and stable economic growth are just not rewarding at this time.”

This is also highlighted by the extended decline seen for market based inflation expectations, and one accompanied by lower oil prices.

There are two important implications from a world of ever-rising negative and lower-yielding government bonds. The first is that it only intensifies the challenge facing a financial sector, reliant upon a nice positive spread between short and long-dated interest rates. The MSCI global financials index has shed 9 per cent in the past three weeks and stands less than 5 per cent higher for 2019. Within this group, European lenders lead the way, with Stoxx 600 financials down 11 per cent this year and at their lowest point since 2012.

Via Brown Brothers Harriman, the list of countries with a 10-year yield below that of their respective three-month rates includes: Australia, Canada, Hong Kong, Singapore, Japan, Norway, UK, US and Switzerland, with Germany knocking on the door. 

As Chris from AXA IM notes:

“Today we can only guess what the potential implications of a prolonged period of negative bond yields will have on the financial sector and the economy. There could be an impact on pension fund valuations, on insurance company solvency and on bank profitability.”

The second consideration and this reflects why long-dated yields have dropped so much of late, is how investors need to insure their portfolios against the risk of economic weakness that challenges the bottom line for companies, with negative results for credit and equity markets.

Government bonds are a hedge for portfolios that own equities and credit. Ian Lyngen at BMO Capital Markets calls this a “cushion” for investors when equities reach the end of the road for the current cycle. Lower yields mean less protection for portfolios and limited scope for any eventual rebound: 

“The wealth effect will be more consequential, leading to even further malaise in consumer confidence and consumption that will elongate the next downturn and recovery. Yet another sign pointing toward rates staying lower, for longer, even if a technical recession is averted in coming quarters.”

In the near term, markets remain a hostage to trade developments that cast a lengthening shadow over the global economy and then there is next week’s annual gathering of central bankers in Jackson Hole, Wyoming.

As I can readily attest, a stint in the mountains is always refreshing, no matter the length of the climbs. This year’s Kansas City Fed Symposium is not shirking a tough challenge, as it focuses on Challenges for Monetary Policy, but the academic nature of such gatherings means investors likely must wait until September for greater clarity over policy options and whether they can counter the bond market’s gloomy forecast. 

Quick Hits — What’s on the markets radar

The equity correction — The recent pressure on equities highlights how the US is managing to hold up a little better. The FTSE All World index, excluding the US, has dropped 8 per cent from its peak in early July. The S&P 500 is off some 6 per cent from its record close in late July, leaving some room before a classic 10 per cent correction is carved out. A test of the S&P 500’s early May low of 2,728 probably looms before the market has grounds for a solid rebound. Indeed, the usual signs of panic remain missing on Wall Street, such as a leap in the CBOE’s Vix beyond a reading of 30, accompanied by a one-day capitulation in the region of 4 per cent.

That kind of one-day drop in the past says DataTrek “is typically a safe entry point for investors with a one year or longer holding period”.

Focus on Inflation Breakevens — US expectations for inflation over the next five and 10 years are below 1.4 per cent and 1.6 per cent, respectively on Thursday. Both represent a fresh nadir for 2019 and the lowest level since September of 2016. Over the past month, the five-year measure has dropped from 1.65 per cent, while the 10-year inflation break-even has fallen from 1.81 per cent.

The lack of inflation worry is a green light for buyers of long-dated bonds that pay fixed rates over time. It also suggests that the Fed has plenty on its plate as the July policy statement noted “market-based measures of inflation compensation remain low” when market expectations were a lot higher. The bond market is not pulling any punches at the moment. 

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