Market Recap

The first quarter ended on a solid note with most equity markets bouncing back from last week’s selling. For the week the S&P picked up +1.2% to bring the first quarter return to +13.1%. The returns for global equities are +0.6% and +11.8% respectively. Not bad considering. As it turns out, this was the 9th best start to the year since 1928, as you can see below.



Bond yields dipped modestly again this week and intermediate-term government bonds gained +0.3% and +2.4% for the week and quarter respectively. The returns for equities aren’t a total shock after an exceptionally weak fourth quarter. Bonds, on the other hand, have put up some surprising numbers. More on this.


That Sinking Feeling


Bond yields lurched lower around the world in the first quarter. Fading growth and inflation expectations are playing a role, but so are changing expectations for central bank policy. Last week it was the growing belief the Fed might cut rates before the year was out that was a big story. This week New Zealand’s central bank unexpectedly hinted at forthcoming interest rate cuts and warned that “the global economic outlook has continued to weaken, in particular amongst some of our key trading partners including Australia, Europe, and China.”


Both Germany and Japan have recently seen the yield on their 10-year bonds swing into negative territory again.



Along these lines, the amount of debt around the world with negative yields pushed over $10 trillion for the first time since September 2017, as you can see below.



Just so we are clear – a negative yield means you are paying the borrower when you buy his bonds. A lot of the $10 trillion are government bonds, but not all. In the past month, France’s LVMH and Sanofi have both raised bonds at sub-zero rates. LVMH’s offering was oversubscribed by six times!! Another head scratcher came from French oil company Total. They issued a perpetual bond (they never have to pay it back) at a rate of 1.75% on Wednesday.  What are the odds a large oil company won’t be around in 20, 30, or 40 years? It might not be high, but its not zero either.


Back in the U.S., 30-year mortgage rates are back down to 4% again. This week’s drop of 0.22% is the largest 1-week drop since December 2008. We are now at the lowest level in 14 months.




So basically anyone who bought a house in the last year might have a shot at refinancing.


A Recession Indicator Flashes Amber


As we noted last week, the recent drop in rates has caused the yield curve to invert, at least at certain points. Earlier this week the spread between the 10-year and 3-month was modestly negative, as you can see below.



This reversed slightly on Friday and the spread widened to +0.02%. But regardless, as you can see above, the last two times this spread was negative for a reasonable period of time (2000 and 2007) a recession soon followed.


But the last two inversions were significant in that they lasted a while. Cam Harvey is the guy who actually found the relationship between the yield curve and recessions. He makes the case that the current inversion isn’t sufficient to call a recession yet. In this piece published in January  he argues the following:


  • QE may be distorting this indicator.


  • That being said, Fed intervention is nothing new. If enough people think the inversion points towards a recession, it could become self-fulfilling.


  • The lag between inversion and recession is long and varied – anywhere from 6 to 48 months with an average of 17 months (for the 10y – 3m spread). The table below from Goldman highlights this.



  • For the inversion to be meaningful it has to last at least a quarter. This is a key point. A quick inversion can mean nothing. Look at the inversion in 1998 – it was quickly reversed by Fed rate cuts.


In essence the message is don’t overreact. But we shouldn’t downplay the risks. An inverted curve is one of the few leading indicators with a solid track record of predicting recessions. And these risks are elevated. The Cleveland Fed puts the odds at essentially 1 in 3, as you see below.


Read their full analysis here.


But What is the Market Really Telling Us?


Today’s low bond yields could be telling us growth is going to disappoint in the months to come and that a recession may materialize. We can’t rule this out, but first quarter growth estimates are picking up. The Atlanta Fed is now predicting growth of +1.7% in the first quarter, as you can see below.



Given that the first quarter is typically the weakest quarter (especially after the government shut down and weather problems this year), this isn’t the red flag it was a few weeks ago.


There could be something else driving yields lower – Inflation, or the lack of it.


Alpine Macro makes the point that lower inflation or deflation can be associated with very low interest rates and inverted yield curves:


“Remember that the yield curve was inverted most of the time during the gold standard, so curve inversion does not readily mean an impending recession. Under the gold standard, price deflation was the norm rather than exception and, as a result, risk premia for bonds turned negative: the longer you put off a purchase, the cheaper goods and services will become, so the time value of money turns positive.”


They argue that the movements in the bond market may be telling us more about future inflation than future growth. It may be signaling that inflation is going to fall more than generally thought. After all, both oil prices and the ISM manufacturing PMI price index are pointing towards building deflationary pressures, as you can see below.



But in reality, we can’t be sure what factor (pending recession or pending deflation) are playing a bigger role. Could be both after all.


But from a policy perspective it really doesn’t matter. There is building pressure on the Fed to react. In retrospect, the December rate hike was a mistake. As Tim Duy notes:


“Since that meeting, the yield curve continues to flatten and invert with the 10s3mo spread going negative last Friday. An inverted yield curve is a well-known recession indicator. As a market participant, you have a choice. Either embrace that relationship in your analysis or reject it on the basis that any signals from the term structure are hopelessly hidden by the massive injections of global quantitative easing over the last decade.


In either case I get the same takeaway: The risk of recession has risen to levels that demand attention from the Federal Reserve. In the two cases of similar spikes in the 1990s, a recession was avoided by the rapid response of the Fed in the form of rate cuts. The times that response was lacking, a recession followed.”


This is going to be a big theme for the second quarter.


Liverpool is a Hard Brexit Winner


While cricket doesn’t have a three strikes rule, politics might. On Friday Theresa May suffered her third parliamentary defeat. Her Brexit deal is about as dead as her premiership. The legal deadline is now April 12th to come up with something otherwise the U.K. will be booted from the E.U.


Two weeks will go pretty quick, but the betting is she plays for more time.


On April 1st there will be another round of indicative votes to see what plan might secure a majority. The idea of joining a permanent customs union might garner more support now. Maybe Mrs. May opts for a general election or even another referendum. Regardless, she’ll use whatever she can to lobby the E.U. for an extension.


But there is good news in all this, at least for Liverpool fans.


At the moment Liverpool stands atop the Premier League in the UK. They haven’t won a league title since 1989-1990, so this is a big deal for those of us who are long suffering Liverpool fans. In the event of a hard Brexit Liverpool stands to gain ever further. A hard Brexit would mean all the European players in the U.K. would have to get a visa. This will take time. They won’t be able to play.


Critically, Liverpool has the eight highest proportion of English players on their team (roughly a third). Their nearest rival, Man City, has only 24%. They will take whatever advantage they can get!! The chart below shows the percentage of English players in each team (y-axis) and where each club stands in the league (red number).



Needless to say, Arsenal fans must have voted Remain.


Seeing as we are talking about football, let’s close on a song. New Zealand’s rugby team has the haka, – Liverpool has a bunch of drunk fans signing You’ll Never Walk Alone.


Stirring stuff!!





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