Should Investors Ignore the Yield Curve?

Cecile Gutscher of Bloomberg reports, Yield-Inversion Fear Pits JPMorgan Against Aviva Fund Manager:

Some have started to fret the bond market is portending a recession. Not James McAlevey.

The fixed-income fund manager at Aviva Investors, which oversees 243 billion euros ($301 billion) of bonds, is instead loading up on risk and yield curve-steepener trades. He expects the U.S. economy to expand -- not shrink.

“The recent trade shocks aside, the U.S. economy looks like it’s on pretty firm footing,” McAlevey said in an interview.

But a key metric may contradict that, which is making some people nervous. The fear: the yield curve is threatening to not only flatten but invert, with longer-term rates set to fall below more immediate ones, signaling a growth slowdown.

Investors scarred by the financial crisis a decade ago are “hard-wired” to react to clues that portend slowing growth and overthink yield-curve shapes, McAlevey said.

The debate intensified in recent days after JPMorgan Chase & Co. strategists noted a slight inversion in money-market forward rates that serve as a proxy for the federal funds rate, foreshadowing the same for two- and 10-year note yields. The takeaway, according to JPMorgan’s Nikolaos Panigirtzoglou, is that the market is bracing either for a Fed policy mistake or the end of the economic cycle.

But in this case the yield curve can’t be trusted because overzealous central bank purchases have pushed down yields and the term premium, or compensation for buying longer-dated debt, according to McAlevey. And that’s set to change as the Fed runs down its balance-sheet holdings, foreign buyers withdraw, and growth and inflation pick up.

“If the term premium goes up through time, the yield curve should start steepening,” he said. He says the gap between two- and 10-year notes, now at 48 basis points, could return to early 2017 levels of about 125 basis points.

Non-resident holdings of Treasuries have already fallen amid a weak dollar and declining appetite for U.S. securities. A recovery in the greenback could even continue this trend as it reduces the incentive for export-orientated central banks to temper local-currency strength, McAlevey said.

“Investors have forgotten that fundamentals move markets,” he said. “Cycles don’t just die of old age; cycles die because there’s a trigger that destabilizes the economy.”

Let me begin my analysis by stating that I don't agree with Aviva's James McAlevey, I agree with JPMorgan’s Nikolaos Panigirtzoglou (and not because he's Greek), and Cornerstone Macro's Francois Trahan, the yield curve matters a lot and there is a real risk it will invert in the second half of the year.

First of all, as I mentioned in my comment on where to invest now, the Fed's balance sheet isn't shrinking considerably:

[...] Karl Gauvin of OpenMind Capital told me he looks at the Fed's balance sheet numbers every week (think he said Thursday) from the St-Louis Fed and he sees nothing has changed significantly, only declined as a percentage of GDP (click on image):

As I stated in my recent comment on the Fed's balance of risks, all this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.

More importantly, apart from its balance sheet (non) reduction, even if the Fed doesn't tighten more aggressively than what the market anticipates, there is a real risk the yield curve will invert as the long end of the curve contracts faster than the short end.

An inverted yield curve occurs when long-term yields fall below short-term yields. Keep in mind, the short end of the curve is influenced primarily by Fed policy while the long end is influenced primarily by inflation expectations and global growth.

The Fed has already signalled it will hike rates four times this year, and Federal Reserve officials at their most recent meeting saw an economy growing at a strong pace and inflation moving up as well, justifying continued interest rate increases.

But even if the Fed doesn't hike rates as much as anticipated, the long end of the curve is heavily influenced by the global PMI which just plunged to a 16-month low, jeopardizing the much-heralded 'global synchronous recovery' of last year: 

After rising confidently for 5 straight months, Global PMI collapsed in March - plunging to 16-month lows, dropping by the most since Q1 2016's global growth scare (click on image).

As Markit notes, global economic growth slowed sharply to the weakest in over a year in March, according to the latest PMI surveys. Although some of the slowdown may prove temporary, the broad-based nature of the weakening suggests growth has peaked. Price pressures meanwhile remained elevated, in part due to supply constraints giving pricing power to sellers (click on image).

To put the decline in context, while the February PMI reading was consistent with global GDP rising at an annual rate of 3.0% (at market exchange rates), the March reading is indicative of 2.5% growth (click on image).

As the Wall Street Journal notes today, cracks are forming in the global growth story, and it's this, not the dog and pony show with China, Russia, Syria, Saudi Arabia and Facebook, which is making investors nervous.

To be sure, geopolitical tensions are driving oil prices higher and there is a potential for a big spike if things get out of hand, but if prices spike, it will act as a tax on consumers sensitive to gas prices, and ultimately be deflationary, not inflationary.

What I found interesting today was how China’s factory inflation slowed for a fifth month, which may help explain why President Xi struck a more conciliatory tone in his speech yesterday.

The last thing China or the world needs right now is another deflationary episode, one that may force them to devalue their currency, exporting more deflation throughout the world.

Getting back to the article above, all this nonsense that foreigners' demand for Treasuries is waning. Earlier this week, Todd White and Macarena Munoz Montijano of Bloomberg reported, Treasuries at 3% Will Tempt $67 Billion Spanish Fund Manager:

CaixaBank Asset Management says it is preparing to buy Treasuries should the benchmark yield break above 3 percent, having lost interest in many European sovereign bonds.

Spain’s biggest money manager, which oversees the equivalent of $67 billion, wants to add U.S. debt to build a “tactical” position, Chief Investment Officer Guillermo Hermida said in an interview at his Madrid office. The purchases won’t need hedging as long as the euro stays in a range of $1.18-$1.25, he said.

“Treasuries are looking more interesting, and our entry point is 3 percent to 3.25 percent” for 10-year notes, Hermida said. “In Europe -- although you can do well with bonds in different short periods, the yields have gotten so artificially low in Europe that they don’t seem attractive to us.”

Bond markets are pricing in the possibility of even higher interest rates in the world’s biggest economy compared with the euro zone, the largest single market. The Federal Reserve is pledging to keep hiking rates through 2018, while the European Central Bank plans to wind up its quantitative-easing program this year -- both potentially pressuring yields to the upside.

The Treasury 10-year note yield jumped to 2.95 percent in February, the highest level since January 2014. It was at 2.81 percent on Friday in London. Inflation in the U.S., which erodes the buying power of Treasury interest payments, will be about 2.08 percent annually over the next decade, as implied by breakevens.

ECB Purchases

Hermida said he thinks the ECB will pull the plug on its asset-purchase program in September -- not wind it down gradually through December as some strategists predict -- but that still won’t make yields attractive any time soon.

Spanish investors are faced with low yields on their domestic debt. The level on Spain’s 10-year bonds fell to 1.16 percent at the end of March, the lowest since October 2016, when the yield dropped to a record 0.862 percent.

“The euro area’s inflation is close to its 15-year average, and GDP is above-average for that period, so we don’t really know why the ECB remains super-loose,” he said.

His CaixaBank team forecasts the yield on the region’s benchmark bond, the German 10-year bund, almost doubling to 1 percent by year-end. That’s still unattractive to Hermida.

“They should have ended QE already.”

I'm not so sure the ECB will end QE or that the yield on the 10-year Treasury note will hit 3% or higher this year. In fact, I openly questioned whether we'll see 3% on the 10-year note in my comment on the bond teddy bear market in late February.

And with each passing month, I'm afraid the risks are mounting that the yield will fall below 2.5% and might plunge below 2% by year-end depending on how bad the economy or global stock markets get.

This is why I recently told you my highest conviction long postion on a risk-adjusted basis is good old boring US long bonds (TLT) which continue to perform well (click on image):

At one point bond bears are going to have to stop listening to hedge fund gurus warning of 1970s style inflation and start really understanding the inflation disconnect.

An astute reader of my blog sent me this:

I'm sorry, but these people claiming that inflation will appear like the 1970s is something I just don't comprehend for the life of me. Again, using FRED, the savings rate was much HIGHER in the 1970s. The CAPEX situation was also very strong. The private debt levels of consumers was low. Today, there is NOTHING that resembles that.

Yes, we have asset inflation because of central banks, but that is it. Also, the inflation appearing in what consumers are spending are 1) homes and rent because the banks/hedge funds used cheap money to speculate in these assets and 2) government led health care and taxes.

Consumers are hanging on because credit is so loose by the banks.

He also sent me a recent comment from Variant Perception, Headwinds for US Manufacturing:

The US manufacturing ISM is currently at levels last seen before the 2008-09 recession. While this reflects the recent optimism about growth prospects in the US, we see several headwinds to the industrial sector.

The top-left chart shows the ISM against the VP Business Cycle Financing Index, which has turned down as a number of central banks have entered tightening cycles. Along with the Fed, the Bank of England and the Bank of Korea have begun hiking, and this increase to the cost of investment will be a headwind to manufacturing. The yield curve’s flattening over the last four years has been dragging the VP US Money Index lower (top-right chart; the Money Index looks at money growth and the yield curve), helped by a recent slowdown in money growth. Rising oil prices affect all sectors of the economy, but manufacturing is particularly vulnerable. The bottom-left chart shows a strong correlation between changes in the oil price and the ISM. Higher oil prices are headwind for the manufacturing sector.

Our stock/bond extreme sell signal is currently indicating that cyclical stocks are overbought. This can work as a fairly robust sell signal for cyclicals (bottom-right chart; click on image to enlarge).

I've been warning my readers to underweight cyclical sectors like energy (XLE), financials (XLF), metals and mining (XME) and industrials (XLI) and overweight stable sectors like healthcare (XLV) and consumer staples (XLP) and interest-rate sensitive sectors like utilities (XLU), telecoms (IYZ) and REITs (IYR).

But bond bears still abound and I realize people are looking at the economy and thinking "how can bond yields go any lower?". The problem is they're looking at lagging indicators like core inflation and employment, not leading indicators like the global PMI.

The core CPI was as expected at +0.2%, but the YoY trend did jump to 2.1% from 1.8% in Feb. There is going to be a price to be paid for last year’s string of wireless-induced 0.1% prints which are falling out of the YoY math. I see 50-50 odds of 3% core inflation by year-end.

— David Rosenberg (@EconguyRosie) April 11, 2018

And others are just outright bearish on bonds.

Below, veteran bond manager Dan Fuss has a bold call that the 10-year Treasury yield will be above 4 percent in two years, but his prediction comes with a big caveat: that U.S.-China trade tensions don’t escalate.

I don't know what all the fuss (no pun intended) is about trade wars, the real threat going forward is the cumulative Fed rate hikes which are starting to bite at a time when the global economy is slowing.

In this environment, I fear the yield curve will invert and bring about a recession in 2019. Stay defensive and whatever you do, hedge your risk accordingly allocating to US long bonds (TLT).