The 2yr-10yr Treasury curve yield spread hit a new cycle low of 32bps this morning as the flattening trend continues. The catalyst for the latest move stems from the Chinese currency hitting a six-month low with that move pushing their equity indices deeper into bear market territory. The concern over the weakening yuan is not so much that it is perhaps being engineered to blunt the impact of tariffs, as it will cheapen the cost of Chinese imports, it’s more the stress it puts on the entire emerging market complex which could once again spark global volatility as in 2015 and 2016 (more on that below). In domestic news, May Durable Goods Orders were weaker-than-expected but April was revised higher offsetting much of the May weakness so call it a push. It is interesting to note that with the global growth story running into some potholes, the odds of a fourth rate hike in December have declined some. A week ago the odds were 57% but today those odds are down to 50%, not a big move but a decline nonetheless. The 10-year is currently yielding 2.84%, up 9/32nds in price as the risk-off tone prevails.
|Economic News||Inverted Yield Curves and Recessions||Agency Indications|
We mentioned on Monday that this week would be dominated more by headlines around trade war rhetoric with an assist from new Treasury supply and the building volatility in European politics. While that is still true we are getting a few economic releases this week that bear watching. One of those was the Conference Board’s Consumer Sentiment Survey released yesterday.
In that survey, consumer confidence came in at 126.4 June versus 128.8 May and 128.0 consensus. Within the survey it was the consumer expectations category that drove the headline reading lower, falling to 103.2 June versus 107.2 in May. That is the lowest reading since December 2017. Could it be the first sign Trump's trade agenda and rhetoric could ultimately curtail consumer spending? To date, the saber-rattling over trade has gone by without much notice from the masses. But with the July 6th date approaching for implementation of the first tariffs, equity traders are getting anxious, and if that anxiety flows down to the rank and file consumer it could imply a softer growth rate in the second half. We don’t have to remind readers that the U.S. economy is two-thirds consumer consumption and if those consumers retreat some from their spending ways due to trade war escalation and increasing volatility in equity markets it could spell some softness in growth expectations.
Another area that is suffering off the trade war tit-for-tat actions is emerging markets. One of the ways Chinese officials have responded to U.S. tariffs is to allow/force the currency to cheapen on a near continuous basis over the last several weeks. The Chinese yuan has now weakened by 5.5% to a level last seen in mid-December. The implication is officials are trying to weaken the currency to cheapen the cost of Chinese goods and thereby offset, in whole or in part, the tariff expense.
The problem with that strategy is twofold: first it risks capital flight out of the country for investors not wanting to suffer the currency depreciation. Officials, however, can employ capital controls limiting that outflow. The bigger issue is with emerging market countries that have to compete with China as exporters and that necessitates a cheapening of their currencies as well. That action, however, increases the cost of dollar-denominated debt that dominates emerging market borrowings. What it means is that trade sanctions, tariffs, etc., once employed initiate a whole series of reactions that go far beyond the tariff. Like ripples in a pond, the reaction moves far beyond the initial impact point. Emerging markets are likely to struggle under increasing borrowing costs and domestic inflation stemming from depreciating local currencies. All that is negative to these countries and negative to global economic output, thus second-half growth expectations are being reexamined.
Meanwhile, with conflicting reports coming almost hourly from administration officials regarding trade sanctions and what is planned, and with the usual tweets that interject even more uncertainty, it’s not surprising equity markets have reacted with selling. What perhaps is surprising is the limited flight-to-safety trades in Treasuries. One reason for that is the obvious need to put supply away this week with $34b 2-year notes yesterday, $36b 5-year notes today, and $30b 7-year notes tomorrow. New supply is working to keep any rallies limited but once we’re past that it could allow Treasury prices to lift with more enthusiasm.
Although the Treasury rally has been limited this week, the dust-up over trade and the weakening Chinese currency has sent the 2yr-10-yr yield spread to a new cycle low of 32bps. If the Fed sticks to 25bps hikes in September and December the yield spread could easily be flat to inverted, assuming no material back-up in long-term rates between now and then. Various Fed officials have expressed concern about not wanting to “force” an inverted curve with fed fund rate hikes but many have also expressed a belief that longer-term rates will rise as the domestic economy continues to grow.
One flaw in that thinking is that with trade war rhetoric on the rise, along with retaliatory actions threatened from affected countries, the growth projections that may have been realistic a couple months ago may be less reliable now, not to mention increased flight-to-safety trades. In the section below we explore in detail the history of inverted yield curves and recessions. The short story is an inverted curve almost always precedes a recession. Thus, absent a back-up in longer-term rates the Fed may be closer to a pause than many may believe, lest they tempt fate and force an inverted curve.
Inverted Yield Curves and Recessions
Some Fed officials have expressed concern about “forcing” the yield curve into inversion (i.e., higher short-term rates vs. lower long-term rates) via rate hikes because of the recessionary implications of an inverted curve. That predictive ability is on display in the graph which tracks 2yr-10yr spreads (white line) and subsequent recessions (light red bars) when inverted. As the spread dips below zero and goes inverted notice in every instance since 1977, the inversion was followed by a recession. If long-end yields fail to increase, the curve could invert after two more rate increases. That could happen by December given the Fed’s current plans.
Agency Indications — FNMA / FHLMC Callable Rates