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 /

  • Equity outlook: The high cost of global fragmentation for US portfolios

    Quarterly Outlook

    Equity outlook: The high cost of global fragmentation for US portfolios

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: Commodities rally despite global uncertainty

    Quarterly Outlook

    Commodity Outlook: Commodities rally despite global uncertainty

    Ole Hansen

    Head of Commodity Strategy

  • Upending the global order at blinding speed

    Quarterly Outlook

    Upending the global order at blinding speed

    John J. Hardy

    Global Head of Macro Strategy

    We are witnessing a once-in-a-lifetime shredding of the global order. As the new order takes shape, ...
  • Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Quarterly Outlook

    Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Jacob Falkencrone

    Global Head of Investment Strategy

  • Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    Quarterly Outlook

    Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    John J. Hardy

    Global Head of Macro Strategy

  • Equity Outlook: The ride just got rougher

    Quarterly Outlook

    Equity Outlook: The ride just got rougher

    Charu Chanana

    Chief Investment Strategist

  • China Outlook: The choice between retaliation or de-escalation

    Quarterly Outlook

    China Outlook: The choice between retaliation or de-escalation

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: A bumpy road ahead calls for diversification

    Quarterly Outlook

    Commodity Outlook: A bumpy road ahead calls for diversification

    Ole Hansen

    Head of Commodity Strategy

  • FX outlook: Tariffs drive USD strength, until...?

    Quarterly Outlook

    FX outlook: Tariffs drive USD strength, until...?

    John J. Hardy

    Global Head of Macro Strategy

  • 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

None of the information provided on this website constitutes an offer, solicitation, or endorsement to buy or sell any financial instrument, nor is it financial, investment, or trading advice. Saxo Capital Markets UK Ltd. (Saxo) and the Saxo Bank Group provides execution-only services, with all trades and investments based on self-directed decisions. Analysis, research, and educational content is for informational purposes only and should not be considered advice nor a recommendation. Access and use of this website is subject to: (i) the Terms of Use; (ii) the full Disclaimer; (iii) the Risk Warning; and (iv) any other notice or terms applying to Saxo’s news and research.

Saxo’s content may reflect the personal views of the author, which are subject to change without notice. Mentions of specific financial products are for illustrative purposes only and may serve to clarify financial literacy topics. Content classified as investment research is marketing material and does not meet legal requirements for independent research.

Before making any investment decisions, you should assess your own financial situation, needs, and objectives, and consider seeking independent professional advice. Saxo does not guarantee the accuracy or completeness of any information provided and assumes no liability for any errors, omissions, losses, or damages resulting from the use of this information.

Please refer to our full disclaimer for more details.

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992