Friday, 13th of July 2018
Friday the 13th… ‘Been there, done that’, it is just another date for a Friday. Looking out our windows we see beautiful blue skies, we hear the summer in the birds chirping all around and we join in their happiness- The world of economics and finance is at last agreeing with our long-standing fundamental outlook! Whilst the week started with another Trump Tariff Bang (may we coin the term as “TTB” or should it be “ATTB”?) which rattled global equity markets and gave emerging markets a further shave… Ouch, followed by a rather bizarre Brexit process in the UK – Shake, Rattle and Roll. Even the Donald found the UK politics strange. And then, not surprisingly if inappropriately, opined publicly that May was bungling it all and that Boris Johnson would make for a good PM… And then there were noises of disagreement from and about North Korea, where some say that Pompeo bungled the talks. Pompeo, Pompeii… Didn’t we already see this before? With one less “i”… And we had the World Cup overhanging all this noise. A little smirk and a smile was found in a story (fake news, no doubt) that made the rounds- UBS conducted 10’000 simulations and predicted Germany would win the World Cup. Goldman conducted one million simulations and predicted Brazil would win. Neither team made it to the semi-finals. Banks also make stock market predictions… Shall we go and take a look at what the markets are saying in response to all this?
We start with a look at our nemesis, the US Dollar- The DXY (trade weighted index) has risen to 95, back to November ’17 highs. At last looking healthy trading at $1.16 for a Euro, costing 113 Japanese Yen and it takes only $1.31 to buy a Pound Sterling. Gold, the emotional hedge against risk, against inflation and general troubles is trading at $1’240, its low for the year and at its 2017 low of November. Oil is trading at $70/BBL, off its high at 74.50 of two days ago, but still handsomely up for the year. The S&P 500 at 2’800 is up nicely for the year, just 50 points or so below its January spike. The NASDAQ composite at 7’823 is at a new all-time high!
Bonds? Well, the benchmark 10-year US Treasury Note is trading to yield 2.84, basically wading in the shallow-end of the yield pool. And if you recall a few weeks ago we had noted that the spread of 2 to ten-year yields had narrowed to a 34Bp level… noises of impending inversion of the “curve” and implicit risk of recession were all around us. Well, now this “spread” has narrowed further to some 27Bp… Morgan Stanley cut its forecast for net U.S. government debt issued by the Treasury by $690 billion through 2020. The bank sees 10-year Treasury yields at 2.75% by year-end, and 2.50% by mid-2019. It previously forecast them at 2.85% for end-2018 and 2.70% for the second quarter of 2019. The yield curve will invert “by mid-2019,” the analysts said. “We suggest an overweight to U.S. Treasuries.”
The yield curve has been flattening almost continuously since early 2017 as the Fed kept raising rates, pushing up two-year yields, while 10-year yields rose by less. An inversion has preceded U.S. recessions in the past, and some Fed officials have expressed concern about that happening. Listen to Federal Reserve Chairman Jerome Powell talk about the U.S. yield curve, and you’d come away thinking the leader of the world’s most influential central bank is powerless when it comes to stubbornly low long-term interest rates. That’s not entirely correct. It’s true that the Fed’s interest-rate hikes primarily boost short-term Treasury yields, while longer-term debt is more sensitive to bond traders’ outlook for growth and inflation. That’s the reason an inverted curve is such a reliable indicator of an impending recession — as officials increasingly tighten policy, the outlook for the economy grows dimmer. In a sense, there’s only so much the Fed can do to lift 10- and 30-year yields. But it could certainly be doing more than it is now, if policy makers were truly trying to avoid an inverted yield curve. If they really wanted to, they could effectively carry out a reverse Operation Twist by selling those long bonds and purchasing shorter-dated maturities. Take a look through the Fed’s holdings, and you’ll see that the central bank holds more than half (and as much as 70%) of some Treasury bonds that mature from 2037 to 2042. That’s almost half a trillion dollars of firepower that officials are choosing not to deploy to steepen the yield curve. As Powell has said, the move higher in short-term rates makes perfect sense because central bankers effectively dictate those. But the fate of long-term yields is in the hands of bond traders. For all the talk of the Treasury term premium, it’s still ultimately an abstract figure derived from a model. The only way to stop the flattening trend, in that case, is for the Fed to hit the brakes on raising short-term rates. But, after the release of the central bank’s June meeting minutes, it doesn’t seem likely to do that, even with investors on edge. It means that even with the yield curve as close to zero as it’s been in a decade, it probably doesn’t pay for traders to fight the flattener.
The world’s biggest bond market just doesn’t know what to do with the prospect of an all-out trade war instigated by the U.S. On one side, there’s a strong argument that tariffs among the largest economies will stifle the global expansion and push yields in the $15 trillion Treasury market lower. Those concerns are appearing in the price of copper, the industrial metal often viewed as a barometer of economic growth. It’s falling relative to gold at the fastest pace since August 2015. That ratio is frequently cited by DoubleLine Capital’s Jeffrey Gundlach as worth watching to assess the next move in interest rates. Right now, that direction would appear to be lower. However, as bond traders were reminded on Thursday, U.S. inflation is as strong as it has been in years. The headline consumer price index rose 2.9% in June from a year earlier, the quickest pace since early 2012. Core CPI is just shy of a post-crisis high, at 2.3%. That may keep the Federal Reserve on its rate-hike path and helps explain why Treasury yields haven’t moved significantly lower with the copper-gold ratio. The nation is still adding jobs at a blistering pace and the unemployment rate is near a 48-year low. Price growth, though at recent highs, is nowhere near the double-digit levels from that era. So, then, what to call this new regime of potentially higher prices and weaker growth? Ian Lyngen at BMO Capital Markets suggests “slumpflation.” To him, one of the under-appreciated data points released Thursday is U.S. real average hourly earnings, which for the second straight month were unchanged from a year earlier. As we have been harking for a while now, the 35-year bond market rally may well be over, some inflation is creeping back in and we didn’t and still don’t fear a fall in bond prices. That said, at the current yield levels we are not enticed to own this asset class.
Arguably, Trump’s words, actions and yet more words have found their release elsewhere – the price of the Chinese currency – the CNY/USD is trading now at 6.70 a big move up from the 6.25 level of late January. THAT is a big move in a rather short time interval. But take a step back and see that it was 6.85 in July last year. Huffing and puffing and all stays the same. Conclusion to all this jumping around- when in doubt, take a step back and get a better visibility with a wide-angle lens of time. For Mark Mobius, there may be worse to come even after the U.S. fired new shots in its trade war with China. The MSCI Emerging Markets Index will likely fall another 10 percent from current levels by year-end, predicted Mobius. The gauge, which has fallen around 16% from a peak in late January could be in a bear market. Developing-nation currencies have also been under pressure, with the MSCI Emerging Markets Currency Index dropping around 6% from a high in late March. That’s forcing central banks from Turkey to Argentina and Indonesia to raise rates to defend their currencies. Despite all the gloom, the 81-year-old investor sees the slump as a buying opportunity and is seeking to raise funds. Would he have a different view had he not been raising capital now? We wouldn’t rush to the EM sector quite yet… when things go wrong, liquidity dries-up real fast there… To help you stay awake at night we add to our fixed income discussion the following fact whereby Global debt has hit another high, climbing to $247 trillion in the first quarter of 2018, according to a report published Wednesday. Of that figure, the non-financial sector accounted for $186 trillion. The debt-to-GDP ratio has exceeded 318 percent, marking its first quarterly rise in two years. We strongly suggest you do not calculate what would be the effect of say a 2% rise in borrowing costs- somewhere in the ballpark of 30% of the US GDP…
For all our leaders, please remember Dylan Thomas’ words – “When one burns one’s bridges, what a very nice fire it makes.”
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