US economy

Yield curve inversion cracks the whip


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The bond market’s relentless rally is providing little relief for equity benchmarks as they test and break important support levels.

Not so long ago, the prospect of higher bond yields triggered a dramatic slide in equities and credit. On Wednesday, falling yields that paint an anaemic picture of future growth and inflation expectations is hurting risk appetite.

Nothing fires up recession anxiety quite like the US Treasury market cracking the whip via a negative relationship between the 10-year yield and that of the three-month bill. A year ago, the 10-year yield was 100 basis points higher than the three-month bill. On Wednesday, the 10-year sits just 13bp below the short-term bill. Not since July 2007 has this important yield curve measure been so negative or inverted.

When money seeks a haven in 10-year government bonds, risk assets start cracking. But it bears repeating that this pressure has been building before the escalation in trade temperature kicked off a tough May for equities and credit. That said, the prospect of a trade war impasse certainly heightens the risk of a stagnating global economy. 

Equity and credit market investors also understand that a pronounced inversion in the US Treasury 3m/10yr tells them the clock is ticking on the economic cycle with the risk of recession looming inside the next 12 to 18 months. Some of the move lower in long-term yields comes from investors seeking a portfolio hedge against their equity and credit assets. 

On Wednesday the S&P 500 fell below 2,800, and also traded through its 200-day moving average of 2,776, marking a 12-week low and duly helping sustain demand for government paper. Europe’s Stoxx 600 index is nearing its 200-day moving average and lows of early March as the 10-year Bund yields approaches its all-time low of minus 0.19 from the summer of 2016. 

While many argue “never fight a central bank”, another dollop of wisdom is “don’t ignore the bond market” when it starts opening the throttle a little wider on a yield curve inversion. Bond bulls also have an ally in the shape of semiconductor stocks, a sector that has taken a kicking from the escalation in trade barbs between the US and China. The Philadelphia Semiconductor index has slumped 18 per cent from its April peak, clipping its gain for the year to around 12 per cent. 

George Saravelos at Deutsche Bank believes a recession is coming and highlights via this chart the importance of chipmakers for global manufacturing. 

George writes:

“Stock prices of the semiconductor sector tend to lead the global manufacturing PMI [purchasing managers’ index] by 1-2 months. This is in line with a recent IMF study we highlighted which points to the global importance of the smartphone cycle. It just so happens that smartphones are at the frontline of the US-China trade war.”

At this juncture, Citi’s global economic surprise indicator has been negative since April of 2018 and sits at a current reading of minus 18.1. Oxford Economics notes:

“The 12-month moving average of the Citi US economic surprise index, which has been an important macro anchor for Treasury yields, has been strongly trending lower in recent months.”

TS Lombard believe the uncertainty triggered by the trade impasse between the US and China will extend the global economic slowdown into the second half of the year. One danger is that US capital expenditures slow materially and weigh on the economy from here. They also highlight how the pain spreads globally:

“A stronger US dollar and weaker Rmb are already hurting emerging markets and major exporters such as Japan and Germany — the FX squeeze is going to get worse.”

The dollar index sits just shy of its April peak, while EM currencies via a JPMorgan index have now eased to levels seen in early October.

Two actions would help stem a larger bout of risk aversion that has the capacity to feed on itself and sink its nails deeper into the broader economy.

The first is some detente over trade between the US and China before the G20 meeting in late June. On that score, the equity market is some way off the kind of losses that prompts a moderation in tone from President Donald Trump. 

The second involves the Fed shifting from its patient policy stance and cutting rates. At the moment, the January 2020 Fed funds contract implies a rate of less than 2 per cent by the end of this year, or in effect 38bp of easing by the Fed. But the prospect of that move looks unlikely at the moment as potential catalysts including lower inflation, falling consumption and business investment, along with heightened equity and credit volatility. 

Not helping matters is that the bond market can certainly give the central bank a run in the patience stakes. During 2006 and 2007, the Treasury yield curve was inverted for much of the time and stayed that way until the central bank finally started cutting rates. 

This is one of the problems when the yield curve inverts: it’s a long-range warning. That usually means many can and do have fun shooting holes in the message. The period of curve inversion from 2006 into 2007 was blamed in part on the global savings glut. Back in 2000, US budget surpluses and a dramatic drop in new Treasury debt sales was a popular culprit for the curve inverting. 

And on Wednesday there are no shortage of naysayers who believe the current inversion is a misleading signal. Some highlight how this episode involves the 10-year yield falling below the three-month bill. Usually, the bill rate rises above the 10-year yield as the Fed continues tightening policy beyond the point of no return.

Another reason for downplaying the curve signal is that it reflects record low-term premiums for Treasury benchmarks, a byproduct of the Fed holding government debt after quantitative easing.

Paul Shea at Miller Tabak + Co notes:

“Alternate measures of the yield curve which remove term premiums, however, are also becoming much flatter. If this trend continues, arguments which dismiss the yield curve’s significance will become complete untenable.”

The notion that “this time is different” — known as the most dangerous words for investors for a good reason — does not wash when the Treasury yield curve moves beyond the flirtation stages of an inversion. The 3m/10yr curve briefly inverted earlier this month and in late March, but the latest episode has a bit more momentum.

A bull whip packs a punch, as any Indiana Jones fan knows. 

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Quick Hits — What’s on the markets radar

When government bond yield curves invert — While the US is attracting plenty of attention, another eye popper is the Australian 10-year government yield plumbing a record low and sliding under the current overnight rate of 1.5 per cent, set by the country’s Reserve Bank. The 10-year yield previously did this in 2015 and a rate cut is expected next month from the RBA, but the direction of travel remains one of lower for longer across leading sovereign bond markets. 

FTSE 100 promotion and relegation race — The football playoffs are over but the next quarterly reshuffle of the UK’s blue-chip index by FTSE Russell looms for investors.

In danger of relegation for the first time since the FTSE 100 index was created in 1984 is Marks and Spencer. Also heading for the drop is EasyJet, while leading the promotion race are JD Sports Fashion and Aveva according to Russ Mould at AJ Bell. But as any footy fan knows, teams near the drop zone cannot afford to have a run of poor games close to the end of the season.

As Russ highlights, there are a number of companies looking vulnerable as a bruising month ends: 

“It will only take a share price movement of a few percentage points to leave Just Eat, Hikma Pharmaceuticals, Sainsbury, Direct Line or DS Smith hovering over the trapdoor.”

Contrarian takes on UK short-sellers — Hardly a surprise that M&S is one of the most shorted UK companies at the moment, but the cellar dwellers are Pearson (formerly the owner of the FT) and Ultra Electronics, which is listed on the FTSE 250. 

Fidelity’s Alex Wright says that while Ultra Electronics and Pearson “have had major issues in the past, they have a more positive future ahead of them”.

In the case of Pearson, which many think is stuck in a prolonged downturn as it struggles with a tough transition from physical text books towards digital services, Wright says: 

“While the UK market lacks many technology leaders, in Pearson it may soon be able to boast the world’s leading digital education provider.”

As for UE, tarred with the brush of aggressive accounting practices, Wright makes the point that recent results suggest the approach is being unwound while “key markets are improving meaningfully, and organic growth is returning”.

He adds:

“In time, I expect scepticism towards the company to recede, and more attention to be given to the high-quality portfolio of defence assets the company owns.”

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.





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