Stumbling into a storm?

Macro 5 minutes to read

Eleanor Creagh

Australian markets strategist, Saxo Bank

Summary:  Asian markets began the week with substantial losses as the region followed Wall Street's Friday example where sentiment deteriorated after the inverted US yield curve stoked recession fears.


Globally, yields are collapsing. In Europe, the German 10-year bund yield has fallen below zero for the fist time since 2016, as Europe’s wilting growth was once again confirmed after PMI readings from Germany and France refuted a Q1 rebound. Germany’s manufacturing slump continued with the IHS Markit manufacturing PMI falling to 44.7, the lowest level since 2012 and considerably missing economists’ expectations of 48. Weakening global demand, the trade war, Brexit and a troubled auto industry are all contributing to the slowdown, stoking fears that Europe could be leading the global slowdown.
The picture got uglier as data confirmed US manufacturing also stumbled. The US manufacturing PMI hit a 21-month low and the manufacturing output sub-index dipped to 51.6, the lowest level in almost 3 years, plagued by softening global growth and weaker external demand. 

The slew of data confirming the global slowdown, coupled with the Fed downgrade to growth earlier in the week, reignited growth concerns causing a collapse in bond yields. Consequently, the gap between 3-month and 10-year rates is now negative, for the first time since 2007, which has previously been a reliable indicator of recession. The yield curve is the best forecasting tool for recessions, having inverted before each of the last seven recessions according to the National Bureau of Economic Research.

This inversion means that the interest rate (or yield) on 3-month US Government treasury bills is higher than the interest rate on 10-year Government treasury bonds. This signals lower interest rates in the futures as demand for longer-term bonds has risen. Conversely, when investors expect the economy to be stronger in the future, the yield curve will slope upwards. Banks borrow short and lend long, thus when the yield curve is inverted the ability to lend profitability is less and hence incentive to lend can be reduced.

Whilst this inversion creates concern, a recession in the near term is not a foregone conclusion. Although if you still believe in a business cycle, a recession is eventually inevitable. Typically, the magnitude of inversion preceding a recession is deeper than current levels and more persistent. That is not to say we won’t see a continued and more pronounced inversion, but before sounding the alarm bells of recession, it is prudent to wait for an improved signal (a deeper inversion, and subsequent re-steepening).

So whilst an inverted yield may not mean a recession is looming right around the corner, it is undeniable that the outlook for the global economy is below par and growth will be subdued. 
This weak data and subsequent inversion of the US yield curve has laid to rest the positivity we have seen in equity markets since December lows. Ahead of last week’s Federal Open Market Committee meeting, the concern was whether the Fed would be able to live up to the market’s dovish expectations. But these concerns turned out to be misplaced as Fed chair Powell at every turn managed to outdove expectations, doing little to quell concerns that the Fed are no longer independent and capitulated to the demands of President Trump.

The Fed has given the punch bowl back to the market. They will “stop with the 50Bs” (the balance sheet unwind), tapering the unwind from May 2019 and ending in September 2019, and have priced out any further rate hikes until next year at the earliest.

But we already knew the Fed had shifted back in January and most of that accommodative bias is priced in, since that January dovish pivot there has been a lot of rhetoric that would suggest that Fed would tolerate running the US economy hot and inflation is nowhere to be seen. The latest dovish chant could just be squeezing the last bit of juice out of an already over extended rally.

Historically a “dovish” Fed is not necessarily a good sign as it announces that an economic downturn is on the way. And the bottom line is growth is slowing.

We are now reaching that point where the weakening fundamentals are catching up with the equity market, the equity market which has been buoyed by buybacks is waking up to the fact that the Fed is not raising rates because US economy needs support and is weak just as we approach the buyback blackout period.

After a quarter of optimism, the realities are setting in and Australia is no exception. The rally in global bond yields has not missed Australia, on Monday morning the 10-year bond opened below 1.8% for the first time on record, and hit a record low of 1.756% as global growth concerns gripped the markets. In the last 20 days, yields have collapsed 44bps, reflecting the deteriorating outlook for the global economy but also the Australian economy and inflation expectations collapsing, something we have discussed at length.
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