Tariffs, Trade, and Argentinian Turmoil
It has been a wild couple weeks in the markets as investors have been caught in the crossfire of slowing global growth, flattening yield curves, and trade war uncertainty. The latest bout of volatility was set off when the Trump Administration announced they would slap tariffs on all of China’s exports. There was a brief respite then Trump decided to delay the hike on many consumer goods until after Christmas (you mean China doesn’t pay after all?), but the uncertainty persists, especially after the Chinese government said on Thursday it will still go ahead and take ‘necessary countermeasures’ to retaliate. One way the Chinese are already fighting back is by allowing their currency to depreciate. As you can see below, the Chinese yuan moved through 7 (meaning it takes more yuan to buy a dollar – a falling line means dollar appreciation/yuan depreciation). This raises the specter of the trade war morphing into a currency war as well.
It isn’t helping matters that countries with large manufacturing bases are struggling. We found out this week that the German economy contracted in the second quarter, as you can see below.
Furthermore, China’s industrial production is growing at its most sluggish pace since 2002.
Finally, a surprise election result in Argentina led to dramatic losses for the Argentinian peso as well as the local stock and bond markets. Stocks were down -46% in dollar terms (the second largest one-day crash in any stock market in the last 70 years) while the currency lost roughly 30% of its value at one point (falling line in the chart below means peso depreciation/dollar appreciation).
Markets are now pricing in an almost 80% chance of Argentina defaulting on its debt given that 80% of the country’s debt is in foreign currency.
Historic Interest Rate Moves
Equity markets around the world have corrected in August, but in the grand scheme of things the selling has been relatively controlled (with the obvious exception of Argentina). The S&P 500 is down a little over -4% this month while the NASDAQ is off about -5%. The two indexes are still up +15% and +19% respectively this year.
The more dramatic moves have been in the bond markets. The yield on the 10-year Treasury hit a low of 1.485% at one point this week while the yield on the 30-year bond fell below 2% for the first time ever!! Global yields have also plunged to new lows. The German 10-year was at -0.71% at one point while Switzerland’s 10-year hit -1.12%. Really unprecedented moves!!
The global stock of negative yielding debt hit a new record of roughly $16 trillion this week.
Probably more amazing, if you exclude U.S. bonds, 45% of all global bonds (government and corporate) trade at a negative yield.
And what really matters to those of us with a mortgage is when will my mortgage rate go negative?? Well, maybe you can get a loan in Denmark. Jyske Bank, Denmark’s third largest bank, has begun offering borrowers a 10-year deal at -0.5%, while another Danish bank, Nordea, says it will begin offering 20-year fixed-rate deals at 0% and a 30-year mortgage at 0.5%.
This is really unprecedented stuff.
Yield Curve Inversion and Recession Risks
Falling long-term rates has triggered a closely watched recession alarm bell. For the first time since December 2005 the difference between the yield on the 10-year Treasury and the 2-year Treasury has fallen into negative territory. You need to squint at the chart below, but briefly this week the line fell below zero.
By Friday’s close the yield curve was once again positively slopped, but the press was all over this story with headlines heralding the coming recession. Of course, there are some caveats. First off, this is a terrible timing tool. If you look back at the last five yield curve inversions, the lag between inversion and the start of the recession can be long and varied (average is roughly 17 months).
Furthermore, the market has a history of doing ok after inversions. As you can see below, the average return between inversion and the start of recession is almost 16%.
And this ignores the false signals. For example, the curve inverted in 1998 but we avoided recession.
But things like yield curve inversions can become self-fulfilling if it causes businesses and consumers to pull in their horns. Also, if banks slow lending activity this could easily trigger a contraction. Clearly recession risks are higher than they were at the end of June, but it is by no means a sure bet.
A Manufacturing Recession
To have greater confidence calling a recession you’ll need to see some of the hard data start to roll over. At least so far, we are not seeing this type of activity. Job growth persists and consumers are still spending. Thursday’s retails sales number was solid, as you can see below.
Both the Philly and New York Fed manufacturing surveys actually surprised on the upside. Growth estimates for the third quarter are running around +2%. Of course, all of this could be lagging data, but we wouldn’t peg the recession odds at greater than 1 in 3 currently.
Even in Germany the news isn’t all bad. Yes, growth contracted in the second quarter, but this was largely due to a slump in manufacturing. The services sector is still doing well, as you can see below. A distinction clearly needs to be made between the recession in manufacturing and on-going growth in the consumer sector.
As The Economist notes:
“Yet a recession is so far a fear, not a reality. The world economy is still growing, albeit at a less healthy pace than in 2018. Its resilience rests on consumers, not least in America. Jobs are plentiful; wages are picking up; credit is still easy; and cheaper oil means there is more money to spend. What is more, there has been little sign of the heady exuberance that normally precedes a slump. The boards of public companies and the shareholders they ostensibly serve have played it safe. Businesses in aggregate are net savers. Investors have favoured firms that generate cash without needing to splurge on fixed assets.”
QE is Again in Vogue
There is one other factor that cannot be ignored and could very well be distorting yield curves around the world. Ultra-dovish central banks. Just in the last week central bankers in Brazil, India, New Zealand, Peru, the Philippines and Thailand have all reduced their benchmark interest rates. Then on Thursday we found out the European Central Bank wants to move in a big way. From the Wall Street Journal report:
The European Central Bank will announce a package of stimulus measures at its next policy meeting in September that should exceed investors’ expectations, a top official at the central bank said.
Speaking in his offices in Finland’s capital on Thursday, Olli Rehn said the slowing global economy would see the ECB rolling out fresh stimulus measures that should include ‘substantial and sufficient’ bond purchases as well as cuts to the bank’s key interest rate.
‘It’s important that we come up with a significant and impactful policy package in September,’ said Rehn, who sits on the ECB’s rate-setting committee as governor of Finland’s central bank.
‘When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker,’ Rehn said.
It is looking more and more likely that the ECB will hoover up as many government bonds as they can in the coming months, and when they are done with that, will start snapping up corporate bonds. This naturally leads to lower bond yields and a flatter curve in Europe. Falling bond yields in Europe and around the world have, in turn, led to lower yields and a flatter curve in the U.S.
Without question liquidity conditions are going to become materially easier in the months to come. A half-point cut at the upcoming Fed meeting in September isn’t out of the question. The Fed still has time to get ahead of the inversion through rate cuts in the months to come. But political risks will persist. How much will Trump risk a recession and a loss in 2020 to make a point about trade? We think he cares more about getting re-elected, but??
I think Tim Duy summarized the outlook as well as anyone:
“In my opinion we should be reasonably concerned about the outlook as recession risks have risen but recognize that a.) the time between yield curve inversion and recession could be long and b.) the Fed has been and will continue to be more dovish in the wake of the inversion than they have been in the past. On the other hand, the risk of continued chaotic policy out of the White House is high and could foster the type of coordinated pessimism that overwhelms the Fed.”
Have a good weekend.
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