Neither Powell nor Trump will prevent the inversion of the yield curve

Neither Powell nor Trump will prevent the inversion of the yield curve

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

As Saxo Bank Chief Economist Steen Jacobsen stated on August 17, “It's not Turkey, it's the debt cycle”. The emerging markets house of cards has grown too high for too long on the accumulation of enormous debt levels and now, in the latest stages of the economic cycle, the music is about to stop. 

The EM selloff we have seen in the past few days, however, is not deterring investors. Some of them actually see it as an opportunity to enter into Turkish and other lower-rated sovereigns that have repriced considerably of late. Although the mind appears wired to expect some sun after the storm – especially in years when central bank policies have supported tight valuations worldwide – we believe that this time is different and that the selloff in Turkey is not an isolated case but a systematic issue that sooner or later is going to spread.

In other words: watch out EM investors, because if Turkish volatility did not shake the tree hard enough, Federal Reserve chair Jerome Powell’s speech at Jackson Hole might just do the trick!

Since Powell took the Fed’s top spot, it has become clear that he leaves no room for doubt: the Fed is focused on US economic data and nothing else. Recently, the US central bank even dismissed stress signals in credit spreads such as the flattening of the yield curve, saying that this time is different… i.e., even if the yield curve were to invert, it would not be a sign of an imminent recession.

The biggest risk of all is that investors starts to perceive that the Fed is no longer independent of the US government

Although it seems like nothing could dissuade Powell from hiking twice this year and four times next year, he could still reverse course on pronounced EM volatility.

The only problem is that this may be too little, too late.

With reference interest rates at 2.0%, a lot of money is already returning home to the US. Seeing this rate rise to 2.5% this year will put EMs in an impossible situation, and will intensify the current trend to sell riskier assets in order to harbour money in products less exposed to local currency volatility. The biggest risks remain in refinancing and as Steen Jakobsen indicated, now that the Turkish lira has lost 38% in value since the beginning of the year the chance of a default within 12 months’ time is elevated.

 A Turkish default would not only redefine risk within the EM world, but it could even give the US yield curve a push towards flattening further as investors flee to the longer part of the curve.

More pressure on the longer part of the curve while short-term yields stay high due to interest rate policies would inevitably result in an inversion. 

Powell’s aggressive hiking agenda is not only making trouble for EMs – it’s also causing problems at home. According to Bloomberg, US high yield corporates have issued 27% less bonds this year compared to the same period last year, mainly due to rising borrowing costs. Lower volumes of high yield bonds issued in the primary market mean that equal demand in the secondary one would still support their value, and this is why we have seen high yields corporates’ option-adjusted spread little changed. 

If Powell continues to hike interest rates until the end of 2019 to 4% as planned, we can expect many of these corporates to be pushed out of business as borrowing becomes unaffordable for them.

In normal circumstances, the Fed holds faith in USD-denominated bonds in its hands. The current political scenario, however, is considerably affecting sentiment in the bond market. We have discussed what a trade war would mean for Treasuries and for corporate debt as a whole, but another factor that may start to weigh in is the message received from President Trump: he’s not happy about the Fed hiking rates.

The biggest risk of all is that investors starts to perceive that the Fed is no longer independent of the US government: If this becomes the case, it could be a game-changer.

If Powell reverses course in Jackson Hole and markets suspect that he’s doing so because of pressure from Trump, investors will need to change their strategies accordingly. Normally, when central banks are influenced by governments, they tend to implement expansionary policy. This means that Treasuries should go up, thus they would be bought while at the same time the investors who have gone short for so long would need to cover their positions, putting further downward pressure on yields. 
This would doubtlessly accelerate a possible inversion of the yield curve.

At this point, it is clear that an inversion will happen. Investors should prepare their positioning because once the yield curve is inverted there may not be a quick way back to the market we have become used to over the past decade.

US 10/two-year spread
US 10/two-year spread (source: Bloomberg)

Quarterly Outlook

01 /

  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.