Friday, 12th of April 2019
“The absence of alternatives clears the mind marvellously.”
– Henry Kissinger
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Markets have had an unremarkable week, with equity indices broadly flat by midday Friday. The issues remain the same: uncertainty over Brexit, the prospects for a US-China trade deal, the steady drumbeat of weaker data amid a global slowdown. But they are not making waves. This week we have therefore decided to get a bit ‘wonkish’ on a subject close to our hearts: the US Treasury yield curve.
The inversion of the US yield curve, which first occurred in December 2018 when the 5Y yield dipped below the 2Y yield, has spawned a host of pessimistic forecasts about the US economy. The unease has grown this year as the inversion has spread further along the curve to incorporate an ever-wider range of points. Typically, an inverted yield curve is seen as a harbinger of recession with investors only quibbling over which yields need to invert (and for how long) before a downturn can be considered imminent. This is because, in theory, a yield curve only inverts when the market expects future growth and interest rates to be lower than they are today: otherwise investors would prefer to buy shorter-dated bonds and reinvest the proceeds at higher future rates. Evidence from past recessions has borne this basic theory out, with the yield curve inverting before every major downturn in recent history. That said, a downward sloping yield curve does tend to overpredict recessions and there is significant uncertainty over the lead-time from inversion to recession. But, investors are understandably nervous whenever the curve turns upside-down. The Fed’s preferred signal – an inversion of 3m and 10Y yields – was even flashing danger for a time last month, although not long enough to concern policymakers.
Still, there are legitimate reasons to believe that this time it’s different. Firstly, the activity of non-US bond investors has a large (and growing) impact on Treasury yields. Interest rates across the US curve are significantly higher than those in most other developed countries, where the outlook for growth is also worse. This has driven conservative foreign investors and sovereigns, who are looking to purchase safe assets and hold them to maturity, into longer-dated Treasury bonds. Secondly, the long-end of the US yield curve has been trending lower since the 1970s, when central banks began to prioritise price stability over other macroeconomic objectives and inflation has moderated. Investors have got used to this new monetary regime and falling inflation expectations have reduced the slope of the US curve in good times and bad. This makes temporary inversions (due to technical flows) more likely, particularly with QE and a glut of global liquidity compressing risk premia and exerting buying pressure directly and indirectly on longer-dated bond yields. As such, a curve inversion may not be the recession indicator it once was, and we await a downturn in hard data before calling time on the US expansion.
Going forward, we expect the US yield curve to gradually steepen over the next 2-3 years. The Fed has been aggressively hiking short-end rates in order to get ahead of inflationary pressures and normalise monetary policy before the next downturn, manufacturing a flatter yield curve in the process. But there has been little pick-up in inflation, despite the fiscal stimulus last year, and weaker global growth has forced the Fed to abandon future hikes. The consequence of this dovish turn has been a rally in rates across the curve but not much change in its shape. If the data turns south, the probability of the Fed cutting interest rates will rise and this will be felt in a sharply steeper curve given the sensitivity of the short-end to the near-term rates outlook. However, if the slowdown proves temporary, then we expect both the Fed and ECB to return to their planned roll-back of asset purchases. This should cause the long-end to sell-off. The ECB is a long way from lifting rates and the Fed has stressed that only when it sees inflation return will it hike rates again, so there could be little move in the short-end at the same time as ‘Quantitative Tightening’ pushes up long-dated Treasury yields. Thus, in both reflationary and recessionary scenarios the yield curve should steepen meaningfully. To be sure, substantial pension fund cash holdings would prevent the long-end from rising too far in response to any improvement in economic fundamentals because a wall of money is overhanging the market. But at least a moderately steeper curve would materialize in a bullish growth scenario.
Moreover, and regardless of the future pace of growth, new ideas are gaining traction in monetary policy circles that could bring change to the Fed’s inflation-targeting regime, with an easing bias in future. Specifically, several economists including ex-Fed Chair Ben Bernanke are calling for the target of 2% inflation at any given time to be replaced with a target of 2% inflation on average over a 12-month rolling period. If adopted, this would cause the Fed to become significantly more dovish than it has been in the past, leading to a spike in inflation expectations and long-end rates and thus a steeper curve.
Of more pressing concern than the latest Fed policy debates is the state of Brexit. Another portmanteau was coined this week to add to the tiresome jargon associated with the process: a Brexit ‘flextension’. This refers to the latest deal struck between Theresa May and EU Council President Donald Tusk, after a long and apparently heated meeting of EU leaders on Wednesday evening. The two agreed to delay Brexit until 31 October, with the UK able to leave the EU sooner if the House of Commons approves the Withdrawal Agreement (including the hated ‘Irish backstop’ proposals). The UK is now highly likely to hold European Parliament elections in the summer, a bizarre outcome which could cost the government support given that the vote to leave the EU took place nearly three years ago and the PM reneged on promises to leave, deal or none on 29 March. Still, when it comes to the Brexit saga, the improbable seems to become the inevitable eventually.
The Sahara has been heating up this week and not only with the steady advance of summer. Protestors in Algeria and Sudan have managed to depose two of the world’s most brutal and entrenched autocrats without sparking civil war or excessive violence. Both leaders ruled their respective countries with an iron fist for decades and their deposition is a warning to other such leaders in Africa, the Middle East and beyond. We may be entering another ‘Arab Spring’ moment where popular protests sweep the region, before they hit a regime determined to stand its ground (as in Syria) or are hijacked by well-organised Islamists. The worry now is that the army who backed the protestors installs a regime similar to that of Abdel Fattah el-Sisi in Egypt. Only time will tell. Meanwhile, General Haftar who leads a rebel government in Eastern Libya has seized his chance to march on Tripoli to remove the internationally-recognised government, purge it of Islamist elements and install his militia allies. If he succeeds and unifies Libya after years of instability, the global community may be forced to legitimise the power grab.
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