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?

Is there a shortage of US Dollars and if so why?

At the moment we are seeing quite a few trends combined which look as though they are returning us to a position where there is a shortage of US Dollars. This is troubling as this was an issue in the genesis of the credit crunch as back then it affected banks and particularly European and Japanese ones. It seems odd as the foreign exchange market is very liquid but maybe it is not liquid enough or at least at the right price. Back in March Pictet Bank provided something of an explainer.

The problem is a spike in the differential between LIBOR and the Overnight Index Swap, or the premium over the risk-free rate non-US banks pay to borrow dollars outside of the US.

The spread has risen to 42 basis points, the highest since February 2012, and up from 25 basis points at the start of last month and just 10 basis points in November.

While the rise does not pose a systemic risk, it has nevertheless raised the cost, and reduced the availability, of dollar-denominated loans for non-US banks by a considerable margin and in short space of time.

It is pretty much back to that level (43) after going above 60 and just for clarity that is 0.6%. Here is the first lesson  of this saga in that in our present world some interest-rates do not seem to have much impact at all as for example I did warn on the third of this month that a rise in Argentinian ones would backfire. Some 9.75% higher later I guess my point has been made for me. However here we have a 0.6% or so at the peak looks in terms of Carly Rae Jepson that it “really,really,really,really” matters. This appears to be driven by two factors the first is that it affects the “precious” otherwise known as the banks and is in US Dollars. Of course the official story is rather different as the excerpt below from the May Inflation Report of the Bank of England shows.

In the years following the crisis, funding spreads narrowed as banks repaired their balance sheets and became more resilient.

I am resilient, we are resilient , it has unexpectedly collapsed ….

US Dollar

This has been a factor as we note that recently the US Dollar has been what we might call King Dollar again. If we use the US Dollar Index or DXY for this we see that it has rallied four points since mid April from over 89 to over 93 now. The bigger turn came at the opening of June 2014 when it has dipped below 80. So the price of the US Dollar has risen too over this phase. Whilst the DXY is now out of date in trade terms as for example the Chinese Yuan is missing it does a job for this sort of analysis as the Yen and Euro are there.

US Interest-Rates and Yields

This has been a case of singing along with Jackie Wilson.

You know your love (your love keeps lifting me)
Keep on lifting (love keeps lifting me)
Higher (lifting me)
Higher and higher (higher

The US Federal Reserve has increased its official interest-rate to between 1.5% and 1.75% and nearly as importantly has been raising the rhetoric about there being more (3/4) increases this year. I am not convinced by this but if we look around markets seem to be accepting it perhaps on the grounds that unlike other central banks the Fed has at least been reasonably consistent.

Also there have been rises in bond yields with the media concentrating on 3% for the ten-year Treasury Note and then 3.1%. But for this purpose more significant is what has taken place at the shorter maturities. The chart below gives us a handle on what has been taking place there.

Let me be clear here this is a financial markets thing rather than a real economy thing but these do have a way of leaking across and tripping up the unwary. Adding to this we are seeing real world effects too as I note this from Reuters.

Interest rates on U.S. 30-year fixed-rate mortgages rose to the highest in seven years as a bond market selloff this week propelled 10-year yields to the highest since July 2011, Freddie Mac said on Thursday………Thirty-year mortgage rates averaged 4.61 percent in the week ended May 17, matching the level last seen in May 2011.

Of course they affect the banks from another route.

Quantitative Tightening

One way that the supply of US Dollars is being reduced is quite basic as the US Federal Reserve has set out to do that explicitly. From a balance sheet which just passed US $ 4.5 Trillion we now see that it has fallen to US $4.36 trillion which put like that may not seem a lot but that is US $140 billion or so. The pace is also picking up a bit so in terms of narrow money or what central bankers have loved to call “high-powered money” there is less of it to go around from this source at any rate.

Crude Oil

This too seems to have been a factor in the recent moves and there is some logic to this as of course the vast majority of oil business is settled in US Dollars. Not all of it anymore but a large proportion. Thus the rise in the price exemplified by the fact that the price of a barrel of Brent Crude Oil is now just below US $80 or some 52% over the past year has also sucked US Dollars out of the system. This is my view is of course mostly a timing thing as the oil producers will then spend them as for example one of the ways the money gets recycled is by the Gulf States buying weapons but we know that timing matters in the credit crunch era. Supposedly because we are more resilient as I look up that particular page in my financial lexicon for these times.

There are many views on this but here is one from a social media exchange I was involved in.

My thesis is the $/oil correlation is a consequence of oil market design/paradigm shift. This began 1st July 2017 & completed a couple of months ago. ie the dollar is now on an If I’m right, when (not if) oil falls the $ will fall with it ( @cjenscook )

Comment

Let us now look at it the other way from the point of view of the central bankers. Let me take you to the US Federal Reserve website where with something of a fanfare it declared this back in the day.

In May 2010, the FOMC announced that in response to the re-emergence of strains in short-term U.S. dollar funding markets it had authorized dollar liquidity swap lines with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank.

They had been gone for all of three months and were supposed to go as my emphasis below returns us again to my financial lexicon for these times.

 In October 2013, the Federal Reserve and these central banks announced that their existing temporary liquidity swap arrangements–including the dollar liquidity swap lines–would be converted to standing arrangements that will remain in place until further notice.

Very little is being used right now as one European bank has taken 80 million US Dollars worth in revolving 6 day credit or there are more than one. But this reminds me of the old wartime analogy of President FD. Roosevelt and loaning your neighbour a hose in case he has a fire. Meanwhile the emerging markets have started to be called the submerging ones.