Written by Jim Welsh
Macro Tides Monthly Report for April 2019
Should the Message from the U.S. Yield Curve Inversion Be Ignored?
In late March the U.S. Treasury curve inverted for the first time since 2007. The trigger was a particularly weak German manufacturing PMI report for March announced by IHS Markit on March 21. The manufacturing PMI came in at 44.7, well below the estimate of 48, and 50 which indicates a contraction.
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The report pushed the 10-year German Bund yield below 0% for the first time since 2016, and ignited a decline in global bond yields. By March 25, $10 trillion of sovereign bonds were yielding less than 0%, up from less than $6 trillion in early October and the most since September 2017.
Since early November estimates for German 2019 GDP have been slashed from 1.8% to 1.0%. On March 7 Mario Draghi cut the estimate for growth in the European Union from 1.7% to 1.1%.
To say the outlook for the EU has become less promising would be an understatement, but it’s possible the degree of negativity has gone too far. Arbor Data Science analyzes search trends for loans and purchases of big items, and key words in financial reports on T.V. and the web to discern trends before they appear in actual economic reports. Pretty cool stuff. Since 2012 Arbor’s six month forward estimate of GDP growth in the Eurozone has been remarkably accurate. Their analysis suggests that Eurozone GDP will be closer to 1.9% in six months. Even if their estimate is overstated by 0.2%, it implies that the weakness in the EU that has generated so much consternation in global markets may be nearing a trough and likely to firm after the middle of the year. There are indications that a turn for the better may already be developing. The IFO of Business Expectations ticked up modestly in March as did the Eurozone Consumer Confidence Index.
Exports represented 47.4% of GDP in 2018 for the 19 primary countries within the European Union. As noted last month, China is the largest customer for E.U. goods and services, which is why any improvement in China’s economy will provide a lift to the E.U. and especially Germany. The January improvement in China’s Total Social Financing was the largest increase since the Peoples Bank of China’s response after the 2008 financial crisis.
The expectation has been that a rebound in credit growth would lead to an improvement in China’s PMI’s. On April 1 the Caixin PMI report for March recorded a marked improvement for manufacturing and services. The Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) came in at 50.8 for March the fastest pace in 8 months and well above the estimate of 49.6. The Caixin/Markit Non-Manufacturing (PMI) rose to 54.8 comfortably above the expansion level of 50 and above the estimate of 54.4. New orders within the Manufacturing PMI report climbed to their highest level in four months and also rose above 50 signaling expansion.
This is significant since a pick-up in new export orders has led to an improvement in the PMI for Europe in a few months. This positive domino effect is why China is one of the keys to how the global economy will perform in 2019 and how financial markets will respond to that level of growth.
Citigroup publishes Economic Surprise Indexes for 35 countries and each Index quantifies the percent of economic reports that come in above estimates or below. Typically, the Index for any country ebbs and flows based on expectations.
After a period of better economic news, expectations for the future rise too far which leads to a period in which economic reports come in below estimates. It should come as no surprise then that the Citigroup Economic Surprise Index’s for the U.S. and the Eurozone have been falling and are below 0%. The slowdown in China, Eurozone, and U.S. is a part of the larger picture of global slowing that has taken hold since last spring.
Arbor Data Science combines all 35 of Citigroup’s Economic Surprise Indexes and calculates what percent of the 35 countries are positive or negative. When global synchronized growth was in bloom in 2017 more than 80% of the surprise Indexes were above 0%.
As the Synchronized growth story unraveled during 2018, the percent fell below 25%, which indicates Synchronized Global slowing according to Arbor. The stunning aspect of Arbor’s analysis is that the percent has fallen to just 6%, which means only 2 of the 35 Economic Surprise Indexes are above 0%.
The last two times the percent has been below 10% was in 2008-2009 during the financial crisis, when global GDP contracted by -1.7%, and in 2003. The International Monetary Fund (IMF) estimates global GDP will slow to 3.5% in 2019 down from 3.7% in 2018. This suggests that negativity about the global economy has become excessive relative to economic reality. The potential for positive surprises in coming months is good and will come as a surprise since expectations are so low.
Since the second quarter of 2018, U.S. GDP has downshifted from 4.2% to 3.4% in the third quarter. On March 28 the Bureau of Economic analysis (BEA) reported its final estimate for U.S. fourth quarter GDP was 2.2% down from its second estimate of 2.6%. Most estimates for the first quarter of 2019 are near 1.5%, so the deceleration since the second quarter of 2018 is continuing.
I expected the slowdown in the global economy and the U.S. to persist in early 2019 as I noted in the January Macro Tides:
“The withdrawal of the liquidity infusion by central banks has contributed to a rapid slowing the Global M1 money supply and global liquidity. This suggests the slowdown in global economic growth is likely to persist in early 2019. The progressive chilling effect on global trade from the escalation of tariffs by President Trump and China is clearly evident from the marked decline in Global Manufacturing PMI New Export Orders. Global trade follows changes in PMI New Export Orders with a lag of 3 months and suggests additional weakening in global trade is coming in early 2019.”
The chart of New Export Orders from the January MT illustrated this (above).
Since early October the 10-year Treasury yield has plunged from 3.248% to 2.356% on March 27. Although the deteriorating growth in the global economy and in the U.S. has provided a supportive fundamental back drop, there were other ‘technical’ reasons. As I noted in the October Macro Tides:
“The 10-year Treasury yield soared to 3.179% on October 3, which is well above the May high of 3.115%. The RSI has so far registered a lower RSI, which is a short term positive divergence and could set up a trading low as long as it is maintained. The positioning in 10-year Treasury futures shows Large Speculators holding a far larger short position now than in March 2017, after which the 10-year Treasury subsequently fell from 2.62% to 2.03% in September 2017. If the 10-year Treasury yield closes below the May high of 3.115% soon, it would increase the odds of a false break out.”
The 10-year Treasury yield closed below 3.115% on October 26 and more convincingly on November 16. In the December Macro Tides I explained how positioning in Treasury futures contributed to the sharp decline in Treasury yields:
“Positioning in the futures market may be the primary reason why Treasury yields have fallen so much. With the economy growing nicely through September and the outlook fairly certain the FOMC would continue to raise rates well into 2019, Large Speculators and Hedge Funds established an enormous 4 short position Treasury futures by early October. The aggregate short position would only profit only if Treasury yields continued to rise. As Treasury yields fell during October, this huge short position generated losses that could only be stopped by buying Treasury futures. This buying caused yields to fall further.”
In the March 11, 2019 Weekly Technical Review entitled ‘Are Treasury Yields About to Decline?’ I discussed why the chart pattern in the 10-year Treasury bond and the Treasury bond ETF (TLT) suggested that a sharp decline in yields from 2.643% on March 11 was imminent:
“It is thus interesting that the chart pattern of the Treasury bond ETF (TLT) suggests that Treasury yields may drop to near the lows reached in September 2017, which was 2.034% on the 10-year and 2.651% for the 30-year Treasury bond. The important feature of the recent rally is that the 10-year yield has closed well below the red trend line connecting the July 2016 low and the September 2017 lows, and has remained below this long term trend line.
Click on any chart below for large image.
“The failure to climb back above this trend line, and the pattern in TLT, suggests the recent decline in yields may be the first leg of a larger decline as the weekly TLT chart illustrates. (Treasury yields fall as TLT rises and vice versa.) The positioning in the 10-year and 30-year Treasury futures is also supportive of a rally in bond prices and decline in yields. Although the Large Speculator short position is not as historically extreme as it was in October, it is high enough to fuel another decline in yields. The key determinant will be a news event that raises concerns about the global and U.S. economy.”
The news event turned out to be the unexpected weakness in Germany’s March PMI.
Whenever the yield curve inverts a torrent of articles and TV commentary emerges. The attention is justified since an inversion between the 2-year Treasury note and 10-year Treasury bond has been a good predictor of recession during the last 50 years. The minutes from the August 1, 2018 FOMC meeting indicate that members discussed what an inversion might mean in the current environment.
“Several participants cited statistical evidence for the United States that inversions of the yield curve have often preceded recessions. They suggested that policymakers should pay close attention to the slope of the yield curve in assessing the economic and policy outlook. Other participants emphasized that inferring economic causality from statistical correlations was not appropriate. A number of global factors were seen as contributing to downward pressure on term premiums, including central bank asset purchase programs and the strong worldwide demand for safe assets. In such an environment, an inversion of the yield curve might not have the significance that the historical record would suggest.”
The historical record shows that an inversion has occurred on average 19 months before the onset of a recession and 24 months prior to the 2008 crisis.
Although the long term record of yield curve inversions is impressive, there are a number of reasons why one should resist the urge to overreact. The average lead time as noted has been 19 months, which is a lifetime in the current environment. The manipulation of the yield curve by central banks since the financial crisis has led to lower sovereign interest rates around the globe and made the current inversion easier to develop and suspect.
The decline in Treasury yields has been facilitated by $10 trillion of sovereign bonds yielding less than 0%. This has never happened before so comparing the current inversion to all the other inversions in the last 60 years seems dubious. If Roger Maris’s home run record of 61 was tagged with an asterisk, this inversion deserves one as well. Although the Federal Reserve increased the federal funds rate to 2.40% in December, the large decline in the 10-year Treasury yield from 3.24% to 2.35% was far more responsible than the rise in short term rates for the current inversion.
The chart pattern in Treasury yields, which suggested a large drop in yields was coming, suggests that once this rally in Treasury bonds is over there is the potential for an even larger increase in bond yields by early next year. The psychology for a big reversal in yields is certainly setting up. In October investors were petrified that the Federal Reserve would blindly increase raise rates in 2019 causing the U.S. economy to fall into a recession. In a head spinning reversal that only Linda Blair from the Exorcist could appreciate, a recent tally shows that fully 76.2% of investors expect the Federal Reserve to cut rates before the end of 2019. Investors believe the U.S. economy will be so weak as to warrant the Fed’s accommodation.
The “term premium” is the additional yield investor’s demand for the risk of lending the Treasury money over a long period like 10 years. The effects of central-bank bond-buying through Quantitative Easing (QE) pushed Treasury yields lower than they might otherwise have been making it easier for an inversion to occur. QE has also caused the term premium to be far lower or negative since 2015, after the ECB began its QE program in earnest. The absence of inflation, despite the cumulative QE efforts by central banks, has led investors to become complacent about inflation and more worried another bout of financial distress has likely contributed as well.
The term premium on the 10-year Treasury slipped from negative -0.46 percentage point at the end of November to negative -0.82 percentage point as of Friday March 29. Chart wise the term premium is near the low in 2016, which sets up the potential for a double bottom and reversal.
The decline in the term premium since the end of November accounts for about half of the decline in the 10-year Treasury yield through March 29. What the term premium giveth the term premium can take away as the experience in 2016 shows. The term premium soared from -0.80 percentage point in July 2016 to +0.22 at the end of December 2016. During this period the 10-year Treasury yield jumped from 1.336% to 2.621% an increase of 1.285%. The increase of more than 1.0% in the term premium accounted for 78% of the 1.285% increase in the 10-year Treasury yield.
With the collective country Economic Surprise Indexes below 10% and so many investors forecasting the Federal Reserve will need cut rates before the end of 2019, the real surprise would be that the global economy proves more resilient than expected, U.S. core inflation drifts above 2.0%, the U.S. economy rebounds after a weak first quarter, and investors begin to worry more about a rate hike than a cut.
The Wild Card is the trade negotiations with China. If a deal is struck, the global economy is going to get a lift as the overhang of uncertainty is removed, business confidence improves, and business investment picks up. If this scenario develops, the transmission for inflation pressures to build quickly is possible since there is no output gap, according to the Bureau of Economic Analysis. Although the New York Fed’s Underlying Inflation Gauge (UIG) has softened a little in recent months (blue line), it is still above CPI inflation and continues to apply upward pressure on prices.
The chart pattern in Treasury yields suggests that once this rally in Treasury bonds is over there is the potential for an even larger increase in bond yields by early next year. After bottoming in July 2016, Treasury yields rose to a high in March 2017 which completed Wave (A) (chart on left below). Since the high in March 2017, Treasury yields have been chopping sideways within a large range that may be labeled Wave (B). The decline to the low in September 2017 represents wave a of (B), the increase in Treasury yields into the high in November 2018 is wave b of Wave (B). The decline in yields since the November high is wave c of Wave (B). Once wave c of Wave (B) is complete, the chart pattern suggests that Treasury yields will experience an increase in yields that is similar to the increase from July 2016 and March 2017, or by more than 1.0%. This increase in yields would be labeled Wave (C) (not shown). 
Within wave c of (B) (chart of TLT on right), wave a ended on January 3 as noted on the Treasury ETF (TLT) $123.86 wave (A). This was followed by an a-b-c correction that ended on March 1 when TLT traded down to $118.64 wave (B). Since the March 1 low, TLT appears to have completed 3 waves up to the high of $126.69 on March 28, which was followed a by a sharp decline on April 1 after the strong China PMI news. If correct, there should be one more rally that exceeds $126.69 to complete wave 5 for wave (C). It would also complete Wave (B) that began in March 2017 on the 30-year Treasury bond yield chart.
Recent sentiment surveys show that more than 90% of traders are bullish Treasury bonds no doubt driven by the Fed’s patience, global slowing, short covering, and the strength of the rally. The chart pattern and sentiment suggest Treasury yields may be near an important reversal zone soon.
As I have discussed often in the Weekly Technical Review, Gold may be setting up for a rally that carries it above $1,400 in coming months. There are many reasons why Gold rallies. Sometimes it’s inflation or a flight to safety as during the financial crisis in 2008, or concerns about geopolitical events or merely the perception that inflation is about to soar. In the wake of the Federal Reserve’s first Quantitative Easing program, Gold broke out above the technically significant level of $1,000 in October 2009. As the Federal Reserve continued to expand its balance sheet from the pre-crisis level of $900 billion in 2007 to $2.1 trillion in June 2010, investors began to believe that hyper-inflation was right around the corner.
As I noted back in 2010 and 2011 hyper-inflation was not coming since most of the money the Fed had created remained in the banking system in the form of Excess Reserves. As long as the money was not gushing into the economy, the too much money chasing too few goods type of inflation Gold investors were expecting simply could not happen. Although this basic understanding was lost on the hyperinflation zealots, it didn’t keep Gold from racing up to $1,920 by September 2011. This is a great example of perception overwhelming common sense.
When inflation failed to rear its ugly head, Gold retraced a bit more than 50% of the huge $1,670 rally from its low of $250 in 1999. After bottoming at $1,046 in November 2015, Gold rallied to a high of $1,375 in July 2016. Gold has spent almost 3 years trading sideways and appears near the end of a triangle that could complete with one more drop to $1220 – $1260 in the not too distant future. If this pattern analysis is correct, Gold may embark on a rally that is similar in length to the rally from $1,046 to $1,375 or $329.
If Gold bottoms at $1,220 or higher, the projection is for a rally above $1,500. The 50% retracement of the decline from $1,920 to $1,046 is $1,483, while the 61.8% retracement would lift gold to $1,586. After chopping sideways for almost 3 years a breakout above the July 2016 high at $1,375 could be explosive.
A trade deal with China that gives the global and U.S. economy a nice jolt could provide the spark. The Fed has made it abundantly clear that it will remain patient and would tolerate inflation above its target of 2.0%, so inflation can average 2.0% over a complete economic cycle. Investors believe markets are discounting mechanisms and ‘tell’ investors what’s coming, if investors are only smart enough to listen to the ‘message’ of the markets.
Right now investors believe the global bond market is telling them the risk of a recession developing in the next 12 months is increasing and inflation is a no-show, otherwise why would bond yields be so low! The circular logic within this argument is silly but widely embraced.
- If the trade issue is resolved (and that may be a big if), economic growth strengthens, inflation firms up, and Gold breaks out above $1,400, what message will investors believe the Gold market is telling them?
- How long do you think it will take for articles to appear suggesting that the Fed may be behind the inflation curve, especially if the core PCE is above 2.0%?
- And how will the 10-year Treasury bond term premium respond?
It is certainly possible that the yield on the 10-year Treasury bond could rise by 1.28% in less than 6 months, just as it did in 2016.
There are certainly a lot of ifs in this outlook, but I think China does want to make a deal. On March 27 President Trump said he would not rescind the tariffs on China for a period of time, even if a trade deal is consummated. China of course objected but allowed Secretary of State Mnuchin and Trade Representative Robert Lighthizer to continue talks in China on March 28.
U.S. Economy
In conceptualizing how liquidity is transmitted into the economy the Federal Reserve is the spigot with banks acting as the nozzles at the end of the hose. Most of the focus understandably is on the Fed since it controls the spigot and whether the flow of liquidity into the hose is increasing or decreasing. But banks play an important role especially at turning points in the economic cycle since banks regulate how much money flows out of the nozzle based on lending standards. The Federal Reserve can lower rates but some of the benefit to the economy can be muted if banks raise or maintain high lending standards.
The Fed has decided to be patient in coming months and they will hold the federal funds rate at 2.40% for the foreseeable future. But if banks increase their lending standards in coming months, that will constitute a tightening of monetary policy even as the Fed remains patient. That’s what happened in 2007. During 2007 and prior to the recession which began in January 2008, banks increased their lending standards significantly, even though the federal funds rate remained at 5.25%. The following is a quote from the March 2007 Macro Tides.
“In January 2007, the Federal Reserve’s quarterly lending survey found that more institutions had increased lending standards than at any time since 1991. Let’s think about what that means in the real world. Even though the Fed has kept rates unchanged for months, monetary policy has been effectively tightened by many lending institutions.”
The Federal Reserve is going to be patient in coming months but it will be important to see that banks don’t increase lending standards when the next survey is released in early May. Although banks did increase lending standards in January, likely in response to some slowing in the economy and the decline in the stock market, they were barely above zero and still below the level reached in early 2016. Banks also increased the spread on loans above their cost of funds. If banks don’t increase lending standards it will provide further confirmation that the recent inversion in the yield curve is not an ominous warning of an impending recession. While the yield curve is important it really doesn’t provide much insight as to what is happening with liquidity.
The economy is far more at risk once liquidity begins to deteriorate since it means companies and consumers are losing access to money. Bank lending standards are a great barometer of whether liquidity is improving or drying up, since banks are the source of liquidity. An indication that the modest increase in lending standards in the most recent Senior Loan survey is not a worrisome sign is the increase in lending that has occurred since that survey was taken in January. Bank lending, as measured by Commercial and Industrial Loans, reached its highest annual rate of increase since early 2018 on March 20 up more than 10.6% from a year ago. If banks had increased lending standards in February and March, the rate of lending would have likely turned down and not increased.
When concerns about the economy rise, investors gravitate toward Treasury bonds and away from high yield corporate bonds. The default rate on high yield bonds increases when the economy slows and soars during a recession. The spread between high yield bonds and Treasury bonds doubled from 4.5% in mid 2015 to almost 9.0% in the first quarter of 2016. Most of the increase was driven by concerns about defaults related to the oil industry after oil fell from $110 a barrel in mid 2014 to below $30 in early 2016.
During the swoon in the financial markets in the fourth quarter of 2018, the spread jumped from 3.1% to 5.4% in early January as oil prices tanked from $75 a barrel to below $50 a barrel. Importantly, the spread has narrowed considerably as oil prices have rebounded, despite rising concerns about the global economy. If the spread rises above 5.0% and especially the January high of 5.4% in coming months, and the yield curve inversion deepens, it would increase the negative message. Right now, the narrowing of the spread suggests the yield curve inversion and the angst about the inversion may be overdone.
Federal Reserve
The FOMC lowered the number of rate hikes in 2019 from 2, as projected at their December meeting, to no hikes at the March 20 meeting. I was asked prior to the FOMC’s announcement what I thought the chances were that the Fed would go from 2 hikes to zero hikes. My answer was that the chance of that was zero percent.
Wrong!
By forecasting no rate hikes in 2019, the FOMC communicated that its window of patience extended through the end of 2019, even as it remains data dependent. The commitment to go from to 2 hikes to no hikes comes with a risk, however small it may be. If the Fed had lowered the number of projected rate increases from 2 to 1, they retained the flexibility of lowering expectations from 1 hike to none at a future meeting, if the future data was weak enough to warrant the move.
However, if a trade deal with China is achieved, the global economy rebounds, oil prices continue to climb, wage and core inflation in the U.S. drifts higher, and the U.S. economy picks up steam in coming months, there is a risk that the financial markets may begin to speculate whether the Fed had again misjudged the economy.
Unfair or not, many market participants believe that Chair Powell did a poor job of communicating in the fourth quarter. Powell used the same words to describe monetary policy after the December 19 meeting and on January 4 when he said quite clearly, “Policy is not on a preset course“. After using these words on December 19, the S&P 500 lost 7.6% in four trading days, but gained 5.5% in the four days after January 4. Those criticizing Powell’s communication skills are conveniently overlooking their listening skills, or more appropriate, lack of listening.
Had the FOMC lowered the expected number of rate increases in 2019 from 2 to 1 at the March meeting, any improvement in the economy in the second half of 2019 would have been covered without the FOMC having to reverse course. If the FOMC is forced to consider raising rates before the end of 2019, it is a much more difficult decision to go from no hike to 1. This has the potential to further erode confidence in the Federal Reserve.
And if this occurs, the FOMC will have shot itself in the foot for no good reason.
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