The bond market surge is the financial news story of 2019

This has been quite an extraordinary year in financial markets and we find that even the summer lull is being very active.Or rather it tried to go quiet and then kicked off again. The good news is that amongst a sea of indifference and sadly ignorance we have been on the case. What I am referring to is the surge in bond markets that has taken them to quite extraordinary heights and changes a large proportion of the financial landscape. So let’s get straight to it and where else to start but with President Trump.

Trade talks are continuing, and…..during the talks the U.S. will start, on September 1st, putting a small additional Tariff of 10% on the remaining 300 Billion Dollars of goods and products coming from China into our Country. This does not include the 250 Billion Dollars already Tariffed at 25%…

So he now plans to expand his tariff trade war to pretty much everything Chine exports to the US. This has had the usual impact of lowering equity markets, strengthening the Yen ( into the 106s versus the US Dollar) and more importantly for our purposes today sending bond markets surging again.

This is our first lesson of the day which is that the financial markets version of economics 101 does still apply in some areas. What I mean by this is that sharp falls in equity markets still make bond markets rally. The logic such as it is comes from the fact that bonds pay a regular coupon as opposed to lower equity returns which makes the bonds more attractive. I am sure that many of you have spotted what Shakespeare would call the “rub” in this so for the moment let our analysis remain in the United States where there still are positive bond yields.

The situation now is that the ten-year Treasury Note now yields a mere 1.84% whereas yesterday I was reviewing a post US Federal Reserve 2,04%. The exact levels will change as this is a febrile volatile environment but the general picture has been singing along with Alicia Keys.

Oh baby
I, I, I, I’m fallin’
I, I, I, I’m fallin’
Fall

I keep on
Fallin’

This has caught out US Federal Reserve Chair Jerome Powell as he was doing his best to pour cold water on the view that interest-rates are about to be chopped. In a sense this shows that whilst central banks have a lot of power they were accurately described by Hall and Oates.

You’re out of touch

Anticipation of the extra US $40 billion of bond purchases on their way via the (even earlier) ending of QT or Quantitative Tightening will have pushed the market higher on their own. But they found that The Donald was there with some petrol and a match. Oh and according to Market watch he may have just found another petrol can.

President Donald Trump on Friday will make an announcement on European Union trade at 1:45 p.m. Eastern, according to the White House’s daily guidance. Trump has threatened tariffs on European Union cars as well as food and alcohol, and plane makers Airbus AIR, -4.54% and Boeing BA, -2.02% have also been the source of trade tensions between the two sides.

So let me conclude the section on the world’s largest bond market with two points. Chair Powell thinks he is in charge but in reality a combination of President Trump and the markets are running rings around him, Next is that the real world economic effects of this will be cheaper fixed-rate mortgages and business borrowing as well as lower borrowing costs for the US government. Leaving us with a view that the Trump era is a curious combination of blazing away incoherently in the moment but also showing signs of an underlying plan as he gets lower bond yields for his fiscal expansionism.

Negativity

He was right by the way it is more today. Also as a nuance the amount of corporate debt that has a negative yield has passed the US $1 trillion mark. A nice little earner for some and of course as we look at the overall picture I find myself musing about future trends.

Glaciers melting in the dead of night
And the superstars sucked into the super massive
Super massive black hole
Super massive black hole
Super massive black hole

The UK

The situation here is remarkable in its own way. Even Bank of England Governor Mark Carney could not entirely blame Brexit for the situation.

Since May, global trade tensions have intensified, global activity has remained soft, and the perceived likelihood of a no-deal Brexit has increased significantly. These developments have led to substantial declines in market interest rates and a marked depreciation of sterling.

Let me give credit to Joumanna Bercetche of CNBC who asked a question about Forward Guidance. After all Governor Carney has been giving Forward Guidance about interest-rate rises through the period that bond yields have plunged. Sadly he deployed the tactic of answering a question he would have preferred to have been asked, gambling that no-one in the press corps would have the chutzpah to point that out.

This matters because we find ourselves in an extraordinary situation with the five-year yield at a mere 0.33% this morning. Firstly let me point out the ongoing excellence of the comments section of this blog as Kevin suggested we would reach 0.4% a while back when such views were deeply unfashionable elsewhere. Next this should be impacting on fixed-rate mortgages as banks can fund very cheaply in this area now although so far there seems to have been little sign of this, so perhaps the banks are keeping the change here for themselves. Finally the UK can borrow ever more cheaply an issue which the media and the “think-tanks” keep ignoring as they pontificate over whether the government can spend more? Of course it can at these yields! Whether that is a good idea or whether it will spend it wisely are different matters.

There is a curious situation in the UK yield curve where the five year yield at 0.33% is below the two-year at 0.42% and the ten-year at 0.55% so let me explain it. We have a 0.75% Bank Rate which in explicit terms only applies overnight but let us more loosely say until the next Bank of England meeting. That has more of an influence on the two-year which is why it is higher. But even so it is some 0.33% below the Bank Rate.

Before I move on let me point out how extraordinary this is by reminding everyone that the last time we were here the Bank of England was involved in making some £60 billion of purchases at almost any price. In fact as it wanted lower Gilt yields back then it wanted to pay more. How insane in the membrane is that?

Comment

It is rather kind of financial markets to help me out here as just as I start typing this section they reach a threshold.

German bonds at -0.5% yield Klaxon.

The benchmark ten-year yield is already telling us what it expects the new ECB deposit rate to be. Or perhaps I should say the maximum as the two-year is at -0.78%.

Let me resume my insane in the membrane theme with this.

Putting it another way here is Bloomberg.

Borrowing costs for house purchases and companies in Italy are at an all-time low

Politicians must wish they had thought of the idea of creating “independent” central banks even earlier than they did……

What could go wrong? Well let me start you off, with a quarterly and annual economic growth rate of 0% it does not seem to be doing Italy much good.

What does risk-off actually mean?

Today I intend to look at a subject which gets bandied about a fair bit but is not always well explained. Along the way we find that some of our regular themes and subjects are in play here. Whilst the concept of risk off may look simple we have learnt in the credit crunch era that such things rarely are as we introduce the issue of perception. One man or woman’s risk-off may seem rather risky to others. Also we have been taught that things that the finance equivalent of economics 101 would tell us are risk-free in fact are not. So let us advance cautiously.

Sovereign bond markets

There was a perception that these were risk-free although as someone who worked for many years in them I was only too aware that you could lose money in them. The bond market in my country the UK saw several solid falls in my time meaning that investors lost money. The risk-free element here was that you would always get your nominal amount back at the maturity of the UK Gilt. Although that always was something of an Ivory Tower definition as in the meantime inflation could and in the UK’s case is usually very likely to eat into the real value of your investment and foreign investors also have a currency risk. As over time the UK Pound £ has tended to depreciate then on average you would be a loser here.

At this point we see that “risk-free” was never really that anyway. Those who recall the heights of the Euro area crisis will recall the European Central Bank insisting that Greek government bonds be recorded as risk-free in banking accounts, or more specifically a risk-weighting of 0. This was something of a further swerve as the ECB with its many national treasuries is not linked to them in the way that most central banks which only deal with one are.

Be that as it may central banks have advanced the case of sovereign bonds being risk-free by the advent of the QE ( Quantitative Easing) era where they have bought them on an enormous scale. This has two main features, investors tend to be too busy congratulating themselves when large profits are made to worry much about the risk assumed. Next comes the concept of the world’s main central banks being effectively buyers of last resort for sovereign bonds and thereby providing a put option for the price. On this road we see that whilst in theory the risks have got higher in practice they may well have got lower because the central bank will not allow falls. The latter argument is reinforced by those of us who believe they cannot do so without revealing that they have not achieved the successes they claim.

Today

The thoughts above are highlighted by the fact that sovereign bond markets have been rallying strongly again over the last week or two. The risk-off theme has seen them rally in a new version of what used to be called a flight to quality. We have learnt that bonds may not be quality but that has been anaesthetised by the likely reality of central bank action. Putting this into numbers the US ten-year yield is 2.37% as I type this compared to this on the 22nd of March.

I will come to the cause of this in a moment but if we stick with the event we see that the ten-year US Treasury Note now yields 2.5%. The Trump tax cuts were supposed to drive this higher as we note that it was 3.24% in early November last year.

This type of risk-off trade has also been seen elsewhere as for example the UK ten-year Gilt yields 1.04%. This has mostly been missed in the wider debate as the UK could plainly borrow if it chose but we seem locked into a belief that borrowing is unaffordable when it is the reverse. The headliner in terms of numbers is Germany which has a ten-year bund yield of -0.11% and therefore is actually being paid to borrow all the way up to the ten-year maturity. Japan is the same although the negative yield is smaller.

Currencies

There are currencies which are perceived to be safe havens and thus see a flow of buying when fear appears. The stereotypes for this were the German Deutschmark and the Swiss Franc. In more modern times not only has the Euro taken over the role of the Deutschmark in the main but we have seen the Japanese Yen not only join the list but often be at the top of it. The present state of play is summarised by Dailyfx.com below.

The Japanese Yen’s current backstory is of course fundamental, with risk aversion stemming from increased US-China trade tensions supporting what is, after all, perhaps the quintessential anti-growth currency play.

The US Dollar has haven appeal too, of course, but the Japanese Yen is certainly beating it at present, with USD/JPY having wilted very sharply back to lows not seen since the start of February.

As they point out the picture is muddied by the fact that there are times that people go “holla dollar” or as Aloe Blacc put it.

I need a dollar dollar, a dollar is what I need
Hey hey
Well I need a dollar dollar, a dollar is what I need
Hey hey
And I said I need dollar dollar, a dollar is what I need
And if I share with you my story would you share your dollar with me
Bad times are comin’ and I reap what I don’t sow.
The other side of the coin is emerging market currencies which tend to be hit and at the moment our eyes are usually drawn to the Turkish Lira or the Argentine Peso. Hence the rumours out of Turkey yesterday that capital controls may be on the way as frankly there is not much else left to try.
The last couple of weeks has perhaps seen a new entry to the charts. What I mean by that is the way that the price of Bitcoin has been rallying and at times surging. As I type this it is above US $8000 on several exchanges which leaves us with plenty to mull as the last year or so has left us observing various crises in the new coin structure.
Comment
I have left to last the main other side of the coin which is equity markets which fall and the go lower. That is partly because of the ch-ch-changes here where even relatively small falls tend to have markets on alert for more central bank easing. This trend has been exacerbated by the way that US President  Donald Trump focuses on the stock market so much. However that does provide another argument in favour of bond markets as for example we have already seen the reverse QE programme called QT given an end date. I have written before that I would not be surprised if we saw more bond purchases by the US Federal Reserve in what would no doubt be called QE4. That could easily be sparked if the Chinese should start to sell their holdings of US Treasuries in any real size.
Thus we see that it is really only a perceived risk-off really and let me conclude by throwing in another factor. For some time individuals have seen foreign property investments as a type of risk-off trade but now we are seeing house price falls in many of the places they invested that may change. Although of course from the perspective of places like Argentina and Turkey that is small-fry and should things really light up again in the Middle-East many things will look relatively risk-free.

 

Current bond yields imply a depressing view of the world economy

Let me welcome you all to 2019 as we advance on another new year. I hope that it will be a good one for all of you. As I look at financial markets there has been a development which in isolation is good news. This is that the US ten-year Treasury Bond yield is now 2.67%. That is good news for US taxpayers as their government can borrow more cheaply in spite of the current shut down of part of it and good news for US mortgage borrowers as it feed into fixed-rate borrowing costs. It compares to this situation which I looked at back on the 6th of December.

Now let us look at the US ten-year yield which is 2.9% as I type this and we see that in basic terms it is predicting a couple more 0.25% interest-rate rises.

I will look at why in a moment but let us now shift to the Wall Street Journal for another comparison.

The yield closed Monday at 2.68%, up from the 2.41% where it ended 2017.

The pattern is described by the WSJ below.

The yield on the benchmark 10-year Treasury note—which moves inversely to price and helps set borrowing costs for consumers and businesses around the world—climbed higher at the start of 2018 as stocks rose and the dollar weakened. Investors were content to look past geopolitical tensions, and bonds’ fixed rates, given expectations for a soaring profits and economic growth……..Now, the yield has retreated from multiyear highs hit in November, falling below 3%

The pattern was that the ten-year Treasury Bond rose to 3.26% and you may recall that there were forecasts of it going above 4% at that time. To be fair “bond king” ( CNBC) Jeffrey Gundlach was looking at the thirty-year yield but that has just dipped below 3% today in a different big figure move. Back in July the St. Louis Federal Reserve looked at why it thought US bond yields were rising.

The expected long-term inflation rate and the expected long-term real growth rate of the economy are the most important factors that influence long-term yields. If bond buyers expect higher inflation or higher real growth, they will expect higher interest rates in the future and thus will demand a higher yield on the bonds they buy today.

Central bankers love this sort of thing but I wish you the best of luck in figuring either out in reality! Especially after the past credit crunch driven decade. We can say that the US economy has performed better than its peers so there is a little light in the fog but the next bit to my mind is more important than we are told.

Bond yields also depend on the uncertainty about these factors, so the volatility of expected inflation and growth also influence long-bond yields, but these variables are harder to measure and have smaller effects.

Yes they are harder to measure but we should not use that as an excuse to say they have smaller effects just because that is all we can find. The period between when that was written in July and now shows us how powerful this can be if we look at the ch-ch-changes. Also this bit has not worn well.

The growth in expected future fiscal deficits is likely to have contributed to the rise in relative yields.

That was true but is even more true now an yet yields have fallen as I pointed out earlier. Financial markets pick and choose which factors are the most important at the time and I note the St.Louis Fed missed out the main driver of bond yields in the modern era which is the impact of the policy of the Federal Reserve itself.

The international picture

I do agree with the St.Louis Fed on this point.

The international yields usually, but not always, move together. (  the U.K., Canada, Germany, Japan, Switzerland)

The next bit is awkward for them to analyse as we are back to the impact of central banking policies again. So Germany for instance has seen its bond yields continue to be driven lower by purchases made by the European Central Bank or ECB which have just stopped. But we see that the ten-year German bund yields a mere 0.18% as I type this. Again in isolation that is a benefit for German taxpayers and borrowers but there is also a problem which is highlighted by this from the Markit PMI from this morning.

The headline IHS Markit/BME Germany Manufacturing
PMI – a single-figure snapshot of the performance of the
manufacturing economy – slipped to 51.5 in December,
down from 51.8 in November and its lowest reading since
March 2016. It marked the eleventh time that the index had
fallen in 2018, down from a record high in December 2017.

The German economy has hit a weak phase and this includes the 0.2% fall in GDP in the third quarter of 2018. But the problem is that long-term it has benefited from a lower currency via replacing the Deutschmark with the Euro and in more recent times it has benefited from low and then negative interest-rates. What else is there? Also regular readers who have followed my regular updates on the weakening money supply data in the Euro area may have a wry smile at this.

but the extent of the slowdown has been somewhat of a surprise.

Central banking policy

This has changed although as ever the rhetoric is in the wrong direction. From Reuters.

The most prominent hawk on the European Central Bank’s board still expects an interest rate hike in 2019 but concedes that this will depend on inflation data in the first half of the year………Sabine Lautenschlaeger, a German who has long called for the ECB to tighten its ultra-loose policy, still hopes for a move next year if data allows.

Actually as we have looked at above the data would be considered grounds for considering an interest-rate cut if the ECB deposit rate was not already -0.4%. In my opinion we cannot completely rule out a rise because just like we saw in Sweden before Christmas there could be an attempt to get back to 0% before things get any worse. But it would be an example of what in itself being a good idea being done with bad timing which means it should not happen.

If we move back to the US the simple fact is that the interest-rate rise of a couple of weeks ago may be the last one. Also due to technical reasons ( the amount of Quantitative Tightening or QT depends on maturing bonds) the bond sales will slow in 2019 anyway, but in a slow down there will be pressure for QE4 to head down the slipway.

Comment

What started as good news leads to a more uncomfortable picture as we note that the real shift has been in economic data. This as we looked at last year got worse as we saw a slow down in monetary data lead to weaker economies around the world. This morning has seen another sign of this. From CNBC.

The moves in pre-market trade come after a private sector survey showed manufacturing activity in the world’s second-largest economy contracted for the first time in 19 months. China’s Markit Manufacturing Purchasing Managers’ Index (PMI) for December dipped to 49.7 from 50.2 in November.

This added to the news that auto sales had fallen by 16% in November in China. We have also seen this from Chris Williamson on the Markit PMI data.

manufacturing indicates that last 3 months of 2018 saw the worst factory output growth since the Q2 2013, with firms having to eat into backorders to sustain production levels. Some temporary factors evident but trend looks worryingly weak

Stock markets have led this and I note that they are lower today although we need to note the extraordinary ups and downs of the holiday period. Also there is the role of the price of crude oil which also was volatile but overall has been falling. It supports bond prices and reduces bond yields but affecting inflation projections and also signalling a potentially weaker economy.

So there you have it as we find that what looks like good news is a signal for bad economic trends. It does show markets responding in the way that they should. The problem is their starting point and for that all eyes turn to the central banks who have driven them there. Get ready for the claims that “it could not possibly have been expected” and “Surprise!Surprise!” We already start with trillions of bonds with a negative yield so what can be gained?