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

Althea Spinozzi

Fixed Income Specialist, Saxo Bank

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.

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

You can access both of our platforms from a single Saxo account.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research 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. To the extent that any content is construed as investment research, you must note and accept that the 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 under relevant laws.

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

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.