Trade war fear deepens US yield curve inversion
The inversion of the US yield curve, a measure investors view as the surest predictor of an impending recession, on Monday became deeper than at any point since the onset of the financial crisis a decade ago, as the US-China trade war spread to the currency markets.
The difference between the yield on three-month Treasury bills and the benchmark 10-year bond, which has turned negative or “inverted” before every US recession of the past 50 years, widened to minus 32 basis points at its worst, after Beijing allowed its currency to weaken against the dollar past the symbolic Rmb7 level.
The renminbi move came less than a week after US President Donald Trump said he would impose tariffs on $300bn more of imports from China starting on September 1. On top of the currency depreciation, Beijing also said on Monday that it would halt purchases of US crops in retaliation.
Fearing the economic damage from an escalation in the trade war, investors piled into the relative safety of government debt across the world, sending yields lower. The yield on Germany’s 30-year government debt sank to as low as minus 0.07 per cent on Monday, another record low.
And the yield on the US benchmark 10-year Treasury fell to its lowest level since 2016, notching its seventh straight day of declines, the longest such streak since 2012. In late afternoon trading, its yield was down nearly 11 basis points to 1.74 per cent. Three-month bills yielded 2.00 per cent, while the policy-sensitive 2-year Treasury yield plunged almost 12 basis points to 1.59 per cent.
“There’s been a resetting of expectations across the globe,” said Gregory Peters, a senior portfolio manager at PGIM Fixed Income. “The US has been an island of prosperity in a sea of weakness, but that looks to be ending as the impact on the consumer side from the new tariffs is likely to be bigger than the previous ones.”
The last time the US yield curve was this deeply inverted was in April 2007 when credit markets were showing the first signs of what would become a global financial crisis.
Investors are weighing whether the sharp escalation in the trade war could provoke the Federal Reserve to ease monetary policy more deeply and quickly than its chairman Jay Powell had signalled at his press conference last week. Mr Powell was speaking after the Fed cut rates for the first time in a decade, a move he called a “mid-cycle adjustment” designed to protect the otherwise relatively robust US economy from deteriorating global growth and trade disruptions.
Mr Trump was quick to criticise the decision and, a day later, threatened the fresh tariffs on China — a move that could weaken the US economy and increase the pressure on the Fed to cut rates further.
“The market is expecting the Fed will capitulate to Mr Trump’s demands and cut rates more than the mid-cycle adjustment implies,” said Jonathan Cohn, the head of US rates strategy at Credit Suisse.
Traders are pricing another rate cut at the Fed’s next meeting in September as a certainty. According to futures data compiled by Bloomberg, there is a 65 per cent chance of a 25bp cut, and a 35 per cent chance that policymakers will agree a 50bp cut.
Those odds could increase further should US markets continue to sell off, according to Nick Maroutsos, co-head of global bonds at Janus Henderson. “The Fed is there to backstop markets,” he said. “They have put all of their cards on the table to explain that, so if equity markets continue to fall, they will continue to cut.”