Investors are well acquainted with the advice of “never fight a central bank”. Another dollop of wisdom is “don’t ignore the bond market” when it sends a strong message.
This year’s decline in global sovereign bond yields has accelerated appreciably during May, fanned by the impasse over trade negotiations between the US and China. This testy bilateral relationship, with Mexico now in Donald Trump’s tariff sights, has only reinforced a pessimistic outlook for the global economy and inflation expectations when viewed through the lens of sovereign yields.
A stark scorecard in bond land reveals Germany’s 10-year Bund yield has eclipsed its 2016 record low of minus 0.19 per cent, while large 10-year yield declines have registered for the likes of Canada, France, UK, Sweden and Australia among others.
Turning to the US Treasury market, all benchmark yields out to a decade loiter beneath the Federal Reserve’s mid-level rate of 2.375 per cent for overnight borrowing.
And this week, a red flag was hoisted with the 10-year note yield dipping well inside that of three-month bills. Not since the summer of 2007 has the yield on a 10-year note dipped 21 basis points below its 90-day peer.
The yield relationship between these two distant Treasury benchmarks briefly inverted earlier this month and then in late March. The latest episode has a lot more momentum and is rattling market sentiment. Such a development tells investors and Fed officials that the risk of a deeper slowdown in the global economy will not spare the US.
Whether this results in a spell of stagnant growth or even a recession, as seen after the Treasury curve inverted during 2000 and from 2006 into 2007, is not certain, but those odds are shortening. One can look at the bond market and think it has run well ahead of fundamentals, but buyers of sovereign paper are being spurred by the likely damage inflicted on global trade flows and business investment as the tone between Washington and Beijing deteriorates.
And at this juncture, Wall Street is some way off running up the kind of losses that would likely prompt a moderation in tone from the US president.
Even in the event of an unexpected trade truce before the G20 meeting in late June, any back up in global bond yields and steepening in the Treasury curve looks limited as the market will wait to see what damage has been inflicted on global activity by the escalation in the trade war.
A lengthy stand-off over trade will overshadow global business confidence and capital investment, while extending the global economic slowdown into the second half of the year. Given the record amount of outstanding US corporate debt, a sharper global slowdown and rising market volatility mean highly indebted companies have less room for pain, opening the door to cost-cutting such as lay-offs.
This only raises the pressure on the Fed to lean towards an insurance rate cut that helps offset the global headwinds blowing towards the US economy.
Such a move by the Fed looks unlikely in the near term as potential catalysts for a rate cut such as lower inflation or falling consumption and business investment have yet to flash red. That was the gist from the Fed’s vice-chair Richard Clarida this week. Once more, the yield curve’s long-range warning appears at risk of being downplayed, as seen twice before in the previous decade.
That won’t forestall market expectations of the need for a pre-emptive rate cut by the Fed this summer, which in turn means low Treasury yields and the prospect of a sustained curve inversion.
That entails tighter financial conditions via weaker equities. A stronger dollar also looms as further declines in global sovereign yields keep Treasury yields well above their leading rivals. Already, emerging market currencies have erased all of their gains for this year, tipping the scales towards a bigger rout, and only heightening the pressure on the Fed to eventually act given the dollar’s global importance.
Some argue that the Fed should wait, owing to the inherent uncertainty over trade negotiations and the trajectory of how slowing economic activity ultimately plays out. While the US consumer and service sector remains healthy for now, barring a sudden cooling over trade from the White House, equity and credit markets face a tough summer.
Unlike other leading central banks, the Fed has room to ease and should heed the message of global sovereign bond markets, along with that from Treasury yields.