Week in Review
What would a week be like without some inflammatory tweets and associated market volatility? I guess that is so 2013!!
Coming into this week the main focus was on the Fed’s Jackson Hole retreat and what Chairman Powell might say about future policy. When all was said and done he didn’t say much new, however President Trump more than made up for the lack of headlines. But first, a quick review of the economic data.
On the negative side, activity in America’s factory sector has contracted for the first time in almost a decade. IHS Markit’s US manufacturing purchasing managers’ index dropped to 49.9 in August, falling below the neutral level of 50 for the first time since September 2009. The ongoing trade war is the obvious culprit here.
Existing-home sales for July came in strong. Total existing-home sales rose 2.5% from June to a seasonally adjusted annual rate of 5.42 million in July, as you can see below. This was better than expected.
Inventory levels also tightened. Total inventory at the end of July fell roughly -1.6% from last month. Unsold inventory is at a 4.2-month supply at the current sales pace, down from the 4.4 month-supply recorded in June. The months supply number is bouncing around the lowest levels since 2002.
We also had data on mortgage refinancing. Basically, consumers are using the latest fall in yields to lower their existing rate. The blue line below shows the refinance index. While not back to the highs of 2015/2016, it is getting close. This is good news for consumer spending going forward.
Leading Economic Indicator
This one was a bit of a surprise. The Conference Board’s leading economic indicator (LEI) increased in July, driven by positive contributions from building permits, initial claims for unemployment insurance and the financial components.
Even with the recent inversion in the yield curve the LEI has strengthened. This is consistent with current growth estimates for the third quarter running around 2%.
Back to Your Regularly Scheduled Trade War
But all of this was background noise. The fun and games started early Friday morning when Beijing announced it would apply additional tariffs of between 5% and 10% on $75bn of US imports starting in September. This move is meant to be in retaliation to the Trump administration’s move earlier in August to impose an additional 10% tariffs on $300bn of Chinese imports. But if truth be told, we are all losing track of who’s turn it is.
Right after China’s move came Powell’s speech. Nothing really new but he did seem to support the view that the Fed will err on the side of easing at the next couple meeting. To quote Goldman:
“In his remarks at the Jackson Hole Symposium, Fed Chairman Powell reinforced the case for additional rate cuts in the face of ‘significant’ risks and an ‘eventful’ three weeks since the July meeting. Powell noted a long list of downside risks, promised to ‘act as appropriate,’ and noted that shifts in the anticipated path of policy have contributed to keeping the outlook favorable thus far…”
For what it is worth, Goldman now sees an 80% chance of a 25bp cut at the September meeting, a 20% chance of a 50bp cut, and a less than 5% chance of no cut. For October they see a 60% chance of a 25bp cut, a 15% chance of a 50bp cut, and a 25% chance of no cut.
But then came the Twitter tirade!!
I won’t rehash the President’s twitter comments here, but essentially:
– Donald Trump said he was ‘ordering’ US companies to start looking for alternatives to China, after Beijing’s new tariffs.
– He also said he will issue a response to China’s retaliation later on Friday (sources in the White House actually told reporters to watch his twitter stream – well that’s just great).
– He’s still not a fan of Chairman Powell. Maybe he thought Powell was going to cut rates today? Who knows? But this tweet garnered a lot of attention:
“My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?”
– He also ‘ordered’ shipping companies to search for fentanyl shipments from China.
As soon as the tweets hit the equity markets swooned while bond yields fell and gold surged. In narrow economic and market terms, analysts saw a couple possible scenarios for Friday afternoon:
– More tariffs on China’s exports, or
– Currency retaliation. China’s yuan has been trending lower of late, and took a decent hit today (chart below – rising line = dollar strength). Maybe the administration try’s something to push the dollar down versus the yuan, although its less than clear they can do much.
Trump chose option #1. Starting in October:
– The $250bn of goods now taxed at 25% will now be taxed at 30%
– The $300bn of goods now taxed at 10% will no be taxed at 15%.
Yield Curve Inversion and Recession Risks
One direct consequence of the President’s tweets was that bond yields resumed their push lower. Both the 2-year and 10-year yields fell Friday and the yield curve briefly inverted between the 10 and the 2, as you can see below.
As we have talked about before, an inverted curve is typically used as an early warning signal for a recession. However, JP Morgan at least thinks today’s environment is very different from what we have seen historically. There are three key reasons.
Real Yields are Low
First off, a definition. A real rate is simply the interest rate you see quoted minus an estimate of inflation. For example, today’s Fed Funds rate is roughly 2.1%. If inflation is running at 1.9%, the real Fed Funds rate is 0.2%. Now JP Morgan:
“First, usually the curve inverts to signal that the Fed has already become too tight. In contrast, real policy rates are barely in positive territory currently, at 0.2%, and could soon become negative again should the Fed cuts further next month. We never had a downturn starting from such low levels of real policy rates as current. Real rates are typically around 3% ahead of recession and around the points of past curve inversions.”
The point here is that recessions typically start because policy is tight. It is far from that today.
Banks are Still Lending
If you think back to 2001 and 2007, each yield curve inversion and recession came about in part because banks slowed or stopped lending. The two lines below shows if lending standards are tightening (rising line) or loosening (falling line). It is clear that during the last two recessions lending standards tightened in a big way. This isn’t the case today.
The Chase for Yield
“In the land of the blind the one-eyed man is king.” Well, in a world of negative yielding bonds the U.S. Treasury bond looks very appealing. As you can see below, there are now over $16 trillion dollars of bonds with negative yields. You can buy a German 10-year at -0.68% or a 10-year Treasury at +1.53%. That positive sign looks appealing to a lot of people.
This demand is probably pushing long-term Treasury yields below where they might have been in the past. By how much? Really impossible to say. But certainly, today’s inverted curve has a good amount to do with very low yields in Europe and Japan.
Have a good weekend.
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