Week Ending: August 16th, 2019 | Published: August 19th, 2019
Equities slumped and bond yields continued their relentless decline as the U.S. yield curve (10s/2s) inverted for the first time since 2007 (see our chart of the week). Barring an escalation of the trade war between the U.S. and China (and expansion to other G7 trading partners), we don’t see enough weakness in the data to justify current North American bond yields. The readings on U.S. inflation and retail sales point to economic strength and firming inflation, two things that should have sent yields higher. However, Argentine political and economic woes added to a long list of geopolitical worries, so there are many reasons for investors to be piling into bonds.
We believe bond yields are disconnecting from their fundamentals (i.e., economic growth and inflation) and momentum has taken control of the fixed-income market where the prevailing attitude is that yields are uni-directional – and that direction is only to go down.
Consider that a long-term owner of a 30-year U.S. Treasury at a 2% yield either believes that U.S. nominal GDP (currently running above 3%) is set to slow to 2% or less for the next 30 years! They must believe this is the last chance to get a yield of this nature (not unprecedented as this has been the Japanese experience for 20 years and counting). Otherwise, their motivation is to hold that 30-year bond because they’re a speculative investor and think 2% yields are headed lower in the near term and care not for the income in this security, but only for the capital gain potential. The problem with the speculator’s view is they’re now subscribing to the ‘greater fool theory’ of investing, where their return is predicated on finding a ‘greater fool’ to buy the asset at an even higher price. The U.S. 10s/2s yield curve inverted because 2-year yields fell further and faster than 10-year yields. We find this puzzling if the reason for yield declines is investors fleeing punitive fixed-income regimes in Europe and Japan. (Can they still be called fixed income with a negative yield? Perhaps fixed rent?) If the U.S. yield curve were falling in a more parallel fashion, the situation would make more sense to us and would not have resulted in a yield curve inversion. We believe the reason investors prefer to take on duration exposure at little-to-no yield advantage is because, in fixed income, more duration equals more capital gain, further evidence that the fixed income market has succumbed to momentum.
We fear that – ultimately – all this ‘greater fool’ momentum activity will end badly. We see risk in the bond market today that we fear is out of line with many traditional views of fixed-income returns. We draw attention to the one-year returns for stocks as all being largely flat-to-down and bonds up a towering 10.3%! We don’t expect a 5% correction in the Canadian bond market, but losses in that range over a six-month time horizon are certainly possible. However, even from current levels, Canadian fixed income still has ample ability to put up high single-digit returns as yields that have fallen 1.5% in 11 months can certainly fall further.
Chart of the Week: Bond Market Flashes Recession Warning – Kinda?
The U.S. 10-year less 2-year yield curve briefly dipped into negative territory, sending shudders through the equity market and ushering in further debate about the signal’s history in predicting recessions. Other bond market metrics are pointing to economic weakness ahead. The U.S. 30-year bond yield hit an all-time low of 1.939% on August 15. The U.S. 2-year yield has also fallen below its 200-week moving average, a sign that has preceded the past two recessions. Either the bond market is right, and a recession is coming sometime within the next 10 to 34 months (the range of lag times between the inversion and onset of recession in the past five occurrences), or the signal should not be considered reliable (given the extraordinary and unprecedented interventions and machinations going on in the global bond market). We wrote at length about the yield curve (see GLC Insights: Inverted Yield Curve) when the U.S. 10s/3-month curve inverted back in March 2019. Importantly, the median time between yield curve inversion and S&P 500 market peak in the previous five inversion instances was 19 months, with a median gain of 24.6%.
The week in review
The U.S. 10-year less 2-year yield curve briefly inverted for a few hours in the early morning of August 14 (with a low of -0.015% at 7:57 EST); by closing it was back into positive territory, but just barely at 0.002%. It then proceeded to gradually steepen, finishing the week at +0.061%.
U.S. consumer prices (July) rose 0.3% m/m (in line with expectations), lifting the yearly rate to 1.8% from 1.6% in the prior month. Core inflation also rose 0.3% m/m (versus +0.2% expected); the yearly rate rose 0.1% to 2.2%.
The U.S. consumer continues to boost the economy, while the manufacturing sector struggles in the face of trade uncertainty. U.S. retail sales (July) jumped 0.7% m/m (versus +0.3% expected), the fifth monthly increase in a row. The control measure (excludes cars, gasoline and building materials) rose 1.0% (versus +0.4% expected). Separately, U.S. industrial production (July) fell 0.2% (versus +0.1% expected).
University of Michigan Consumer Sentiment (August) fell to 92.1 (versus 97.0 expected) from 98.4 in the prior month. The NFIB Small Business Optimism Index rose 1.4 to 104.7 (versus 104.0 expected).
German real GDP (Q2) fell 0.1% q/q. More recent data points to challenged growth in Q3, suggesting the German economy could be headed toward a recession.
Weaker-than-expected Chinese economic data suggests the trade war with the U.S. is hurting growth. Chinese industrial production (July) rose 4.8% y/y (versus +6.0% expected), marking the slowest pace since 2002. Retail sales rose 7.6% y/y (versus +8.6% expected), while fixed-asset investment increased 5.7% YTD (versus +5.8% expected).
The week ahead
Canadian inflation and retail sales data
U.S. housing data
Minutes from recent Fed and ECB meetings
U.S. Federal Reserve Chair Powell speaks at Jackson Hole
Purchasing manager indices globally
Royal Bank and CIBC kick off Canadian bank earnings reporting