The Weekly - Can we trust the yield curve after Quantitative Easing?

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01/04/2019
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There has been a lot of chatter over the last week or so regarding the inverted yield curve in fixed interest markets and how this has historically been a predictor of recession. We are constantly reminded in the investment industry that past performance should not be used as a guide to the future and indeed, we remind clients of this regularly as instructed by the FCA. However, this is exactly what many investment commentators and economists have been doing over the last week. The old city joke should not be forgotten which says that economists have correctly predicted eight of the last three recessions, and so we have to keep this in perspective and not set the hares running!  

However, it would be foolhardy to dismiss the evidence too readily. Psychologically it is all too easy to ignore the warning signs when markets are still providing a decent return, especially when cash and fixed interest returns are derisory, as this is the natural hiding place if the view is that equity markets are about to price in a recession. In addition, many seem to consider the ‘r’ word as the end of the world when in reality, all it may indicate is a pause for two quarters ahead of the next growth phase. So, what is all the fuss about and do historical references still apply in this quantitatively eased fixed interest world? 

Well, it is indeed true that the yield curve in both the US and UK is now very flat whereas normally one would expect a higher rate of interest for lending to the government for a longer period. More specifically, the 10-year US Treasury yield is slightly below the equivalent 3-month figure. This is the first time this has happened since 2007 and it certainly was a great predictor of what lay ahead back then, - probably the most significant economic event in most investors’ lifetimes. It was also a prescient warning ahead of the technology bubble bursting. On both occasions, it would have saved an investor a lot of money as the equity market subsequently halved over the next two years or so.  However, in both cases the economic numbers had started to roll over on a global basis and this tends to feed on itself. For example, right now China is feeling the heat of US tariffs, slowing its economic growth. Demand from Chinese consumers is reduced as they become cautious, which in turn causes a drop in sales for German cars and Apple iPhones. This reduces profits in Germany and the US, whilst the German economy is now skating on the edge of recession. So, there is something in this which does make sense but there are also reasons to be cautious regarding predicting a global recession. 

In both the historical examples cited above, economic conditions were extremely favourable in the period prior to the yield curve inversion. Interest rates were low, liquidity and profits strong and GDP buoyant. However, inflation was picking up as confidence became exuberant and stock markets were soaring. The yield curve inverted because short term rates had to increase rapidly to put the economic brakes on and curb the excess. This is not the same today - economic growth has been subdued and is slowing in China and the US, and inflation is benign, such that the Fed and the Bank of England have pledged to stop increasing rates for the time being. 

There is also another fundamental difference to history. We have not had a normally functioning fixed interest market since the credit crunch and the Fed has only very recently begun reversing its Quantitative Easing (QE) buying programme. When QE was occurring, the central banks bought long-term government bonds, which had the desired effect of depressing the long-end of the yield curve and as such, the central banks still own a significant proportion of the Treasury markets. As short-term interest rates have risen, it was inevitable that the yield curve would become inverted sooner than is typical in the economic cycle as the Fed and the US Government is currently sitting on 38.2% of the US Treasury market as at June 2018 (Source: US Treasury). They have not sold these positions down in pursuit of more attractive investment opportunities (as would normally be the case as the economy expands) which has prevented an increase in the long-end of the yield curve with economic expansion. Investors also tend to avoid the long end of the yield curve when growth expands as they expect interest rates to rise at some point as inflation increases, especially as the Fed has been implementing a policy of interest rate normalisation. However, those natural sellers have been relatively small as so much of the long end of the Treasury market is held by the central banks who are not going to sell.

Critics would cite this as yield curve distortion, keeping zombie companies alive and stunting growth whilst contributing to the productivity puzzle. Very recently, the US Federal Reserve has been increasing rates in order to normalise to whatever level the economy can tolerate. It would appear that we have now found that rate at 2.5%, not helped by President Trump’s policies of tax cuts and tariffs which have temporarily boosted US growth and then impeded it. In fact, at the time of writing, the 3-month treasury has risen by 73 basis points over the last year whilst the US 10-year treasury has fallen 35 basis points, hence the inversion (Source: AlphaTerminal).

Of course, we shouldn’t be too eager to ignore this development as clearly the markets are not, but it should be put into context by looking at the more reliable economic indicators, such as unemployment and manufacturing output which remain satisfactory. Also, when the yield curve has inverted previously, it has followed an economic boom as much weaker economic data came through – we have not yet had either. Undoubtedly, the global economy is slowing and some of the PMI leading indicators are cause for some concern. The US economy has indeed weakened slightly, but Donald Trump is likely to announce a new trade deal between the US and China in due course which could inspire another leg of economic growth and optimism. It is this trade war which has caused much of the volatility, caution and market weakness over the last six months. Indeed, Janet Yellen, ex-chairwoman of the Federal Reserve also concluded last week that the yield curve is not a reliable economic indicator at present. 

So, as we all often say (but perhaps this time it is more relevant than usual), past performance of the economy after a yield curve inversion is not necessarily a guide to the future, but it is probably a good idea to be a little cautious and be alert to signs of recession. Ever since the credit crunch, which most investors missed, we have been terrified of missing the next calamity and are consequently looking for black swans and early warning signs around every corner. One day, they will be right, as with all perma-bears and harbingers of doom, but right now, there are yield curve distortions from QE which may lead to the wrong conclusion.

 

Uncertainty mounts as May’s Brexit deal defeated once again

Last Friday was supposed to be the day that the UK left the European Union. Instead, the Prime Minister’s Brexit deal was voted down for a third time whilst indicative votes held across Parliament failed to provide a suitable alternative to her plan. A general election is being touted as a potential method of breaking the deadlock although that could well serve to cause more damage than good. Expect plenty more plot twists ahead of the next supposed Brexit date in 12 days’ time.

Unsurprisingly given the mounting uncertainty in Westminster, Sterling endured a difficult week. It dropped by -1.4% against the Dollar to $1.303 and -1.0% versus the Euro to €1.160 as traders assessed the ever-changing Brexit backdrop. This acted as a boost for the FTSE100 due to the bulk of its profits being generated overseas. The UK main market rose by +1.0% whilst the more domestic focussed FTSE250 added +0.6%.

Elsewhere, the S&P500 benefited from a rally in the Industrial sector to rise by +1.2%; the American market is now more than +13.0% higher year-to-date. Despite the ongoing Brexit stalemate, European markets enjoyed a positive week with the MSCI Europe ex-UK index increasing by just over +1.0%. In fact, the only main market to disappoint last week was the Nikkei 225 in Japan, where growth fears led the market -2.0% lower.

In the sovereign bond market, yields continued to inch lower with the UK 10-year gilt briefly falling below the 1.00% threshold as the trading week drew to a close. The US equivalent yield declined by a further 4 basis points to 2.42%; it had been as high as 3.22% back in November.

With regards to commodities, oil continued to feel the benefits from restricted OPEC supply. Brent crude rose by +2.0% to $68.39 a barrel and has now risen by more than +31.0% since the start of the year. Meanwhile, Gold dropped below $1,300 after a weekly fall of -1.3% left the precious metal at $1,296 an ounce.

Data sources - Datastream and Forex Factory - Accessed 01.04.19

The week ahead

Production indices from around the world are due this week with headline releases expected from the UK, Eurozone (final), China (Caixin) and the US (ISM). With concerns regarding global growth ramping up in recent months, the data which covers March is likely to receive plenty of attention. The domestic manufacturing PMI has already been released this morning with the 55.1 reading beating expectations by nearly 4.0 points. Businesses have been ramping up their preparations ahead of potential Brexit related disruptions.

Other numbers to keep an eye on include Eurozone CPI inflation and unemployment, both of which are expected to have remained at 1.5% and 7.8% respectively. The major US release this week arrives on Friday in the form of the labour market report which includes updated data on unemployment, job creation and wage growth. Job creation is expected to have rebounded strongly last month after disappointing back in February. Japanese activity is limited on this occasion.

Data sources - Datastream and Forex Factory - Accessed 01.04.19